OVERVIEW OF PAKISTAN'S BANKING INDUSTRY

FOZIA AROOJ
(feedback@pgeconomist.com)
Mar 8 - 14, 2010

Banking is one of the most sensitive businesses all over the world. Banks play a very important role in the economy of a country. Pakistan has a well-developed banking system, which consists of a wide variety of institutions ranging from a central bank to commercial banks and to specialized financial institutions. The country started its journey without any worthwhile banking network in 1947 but witnessed phenomenal growth afterwards.

Pakistan's banking industry has made its name in international ratings, ranks 25th amongst banks in the Financial Intermediation Pillar and 2nd in performance and efficiency indicators among the South Asian countries of the World Bank. Pakistan's banking industry remained remarkably strong and resilient during the global financial crisis.

Banking industry has been thriving by leaps and bounds during last couple of years in Pakistan. However, the economic downturn as well as adverse business climate affected it badly after 2007. Before the beginning of financial collapse in the United States and Europe, the banking industry was booming in Pakistan and many foreign banks were eager to enter the industry. However, when the impact of financial meltdown was felt locally, the State Bank of Pakistan sharply increased the paid-up capital requirements apparently to minimize risk and encourage small banks to merge with large banks. This factor led to capital restructuring of the banks at a larger scale.

The performance of banking industry is reflected in a recent report by State Bank of Pakistan which exhibits that the banking spread increased in financial year 2009, and the average spread has been the highest since 2003. Spread for Dec 2009 was 7.35% against 7.75% in Dec 2008. However, the average banking spread for 2009 stood at 7.48% against 7.29% of the average of 2008. The year 2009 recorded double digit inflation while the deposit rate was slightly higher than half of the inflation. The higher spreads indicate inefficiency of banks. They are making huge profits for their shareholders. Banks offer low returns to their depositors. This problem is hampering deposit growth very badly. But the dominance of a few large banks with substantive market power, access to low cost funds due to their extended branch network, age-old captive clients and related economies of scale and scope impede efforts of achieving an efficient pricing of deposits.

Banks are not only required to raise more deposits by offering adequate returns to depositors-which is likely to impede the short-term growth in interest rate income-but they also need push up lending more to the private sector for achieving larger and gainful employment of funds amidst government's efforts to cut its bank borrowing. In the last fiscal year, banks had made net fresh loans of Rs18 billion only to the private sector and they remained reluctant to lend to the sector on account of less than 3% growth rate of the economy and grim future prospects leading to exorbitant growth of nonperforming loans. The NPLs of the banking industry have crossed over Rs400 billion while the chances of recovery are bleak. The lending rate is still high, which has made the cost of doing business much higher in the region. The higher lending rate is the direct outcome of the policy interest rate, which is also the highest in the region.

The monetary growth (M2) was much higher than last year, which creates fears among the economic mangers that inflation will once again creep in to the economy and might take the field as it did in financial year 2008 when the average inflation was 20.5%.

ISLAMIC BANKING

In 1975, the world's first full-fledged Islamic bank was formed in Dubai. Islamic banking is an alternate to interest based banking system. Hence it requires an independent and specific Islamic system. The fundamentals of both the banking systems are different. The ideal mode of financing under Islamic banking system is financing on profit and loss (PLS) basis. Unfortunately most of the Islamic banks are operating parallel to conventional banking. They have adopted the mode of financing on fixed rate of return basis and not on PLS basis. The true modes of financing under Islamic banking system are Musharakah and Mudarabah based on PLS. But during the year 2008, the Islamic banks extended only 2.3% of their total funding under these modes of financing and 92% under Murabah, Ijarah and Diminishing Musharakah based on the mutually agreed fixed return corresponding to the prevailing fixed interest rates system under the conventional banking.

While recognizing the benefits of the Islamic banking, its disadvantages in the modern era cannot be ignored. First, the profit-and-loss sharing (PLS) modes of financing are not the dominant part of Islamic banking as in the case of other forms of conventional banking, the difference between these two types of banking is ambiguous. The Islamic banking is not Sharia-compliant in true sense. But the Shariah advisor of bank certifies in the annual accounts report that the affairs of Islamic banking division are carried out in accordance with rules and principles of Shariah. Islamic banking world over grows at the rate 15-20% per annum. Its growth is not confined to Muslim countries but also it is in the secular countries.

FUTURE OUTLOOK

Banking experts are of the view that the banks would continue to suffer because of bad performance of the economy, which has already crippled many industries resulting in piling up of huge non-performing loans in the balance sheets of the banks. Experts forecast that in 2010, average spread would be at 7.20 - 7.25% only 23-28bps lower than 6-year record level of 7.48% in 2009, while almost at par with the level in 2008.