Banking Sector: Challenges and Opportunities

Banking Sector: Challenges and Opportunities
The last two years have been extraordinary for financial sector globally – both obstacles and opportunities alike. In the aftershocks of the global financial meltdown, domestic economic vulnerability and political instability, the solvency of banks came under serious stress tests. Add on to it tight monetary policy pursued by State Bank of Pakistan (SBP) and banking sector’s performance is under further pressures. However, backed by the strengths gained over last few years, presence of high quality capital cushion and effective systemic regulation form SBP, the sector has shown remarkable resilience in combating both domestic and international crises – apart from financial weakness in some small banks. In the wake of rising costs of business, both in terms of risk and inflation, exploring novel avenues of growth may be a hard task; mending domestic macroeconomic conditions and comparative exchange rate advantage gained provide platform of expansions for banks.
Expansions in capital and assets of Banks had undergone major setbacks in during 2008-09. Despite continuation in rapid credit expansion in 2008, successive increments in interest rates, high inflation, and fragile macroeconomic profile caused significant decline in profitability of banks. Corporate sector, which provides bulk of business to banks, took a serious hit. Although major bankruptcies were low, subdued economic growth and erosion of equity base for large businesses resulted in 64% increase in Non Performing Loans (NPLs) to PKR368billion in 2008. 62% of incremental NPLs were classified as substandard and doubtful (early stage) while 78% of banks saw an increment in NPLs. This lends credence to the fact that business failures are mainly due to cyclical downfall in economic activity, although part of them can be attributed to imprudent lending in 2006-07.
Another key strain on Bank’s resources was liquidity risk. Through 1st half of 2008, system carried excess liquidity; however a number of factors started liquidity drain later in the year. First, expansion in overall bank deposits failed to keep pace with ambitious credit extension. Despite witnessing a 17% increase in remittance based inflows and onset of 5% floor on PLS accounts, deposit growth remained stifled. Banking sector was able to mobilize a mere 9.4% growth in deposits in 2008 against 20.4% increase in 2007. The growth decelerated due to stiff competition from National Savings Directorate, which offered higher profit rates. Subsequently, banks increased borrowings from financial institutions (up by 10%) which, in a high interest rate environment, increased cost of funds. Second, lower economic confidence spiked demand for currency. By October’08, continued increases in inflation due to international commodity price rally, floor on KSE-100 index to avoid decline in equity prices, falling foreign exchange reserves, and period of unstable political transition had caused widespread panic in financial system. This caused massive drain on already decelerating banking deposits while liquidity permium jumped to 1720 bps. The situation was tackled in the short-term by quick regulatory changes, such as easing of reserve requirements for banks. However, liquidity shortfall has continued in the system since then due to substantial borrowing requirements of government which is crowding out funds for private sector.
Small borrowers are characterized by higher credit risk. Due to structural riskiness in Small and Medium Enterprise (SME) and agricultural financing, loan portfolio of banks is skewed towards larger corporate borrowers. By end 2008, 0.5% of borrowers with loan size PKR10million and above accounted for 72% of total advances in the system while 63% of total loans were provided to corporate sector. This portfolio mix indicates a general approach of banks’ in credit management in times of recession; it increases the incident of credit concentration risk. Further credence to this claim comes from the fact that textile sector, with highest share in corporate loans (19.5%) has the highest infection ratio (NPLs to total loans) of 14.6%. IN 2008, SME, agricultural and consumer financing had infection rates of 15.8%, 15.8% and 6.9% respectively compared to 8.9% average for corporate. Since SME financing has proved to be a risky venture for Banks historically, it is rational for individual banks to pull back funding at the first sight of crisis – thus, impairing SME’s debt service capacity in the short run and weakening business environment in the long run. To sum, fragile demand globally and weak growth capacity domestically caused structural obstacles to local businesses and in turn badly affected banking sector’s asset and capital quality.
Despite going through period of low profitability, increasing NPLs and high cost of funds; effective regulatory framework has kept Pakistan’s banking industry on solid footing. For 2008, capital Adequacy Ratio (CAR) stood at 12.3% against a minimum requirement of 9% under Basel II framework while core-capital constituted 83% of total capital. Though total liquid assets for banks declined to 28%, the advances to deposits ratio was 72% indicating that banks are in a strong position to meet liabilities and remain solvent. These trends are positive signs for the liquidity and solvency of banks. However, the lagged impact of decline in assets quality from NPLs and presence of smaller weak banks in the system might have implications on capital positions of banking sector in the future.
Having a strong capital cover internally and growing opportunities externally, banks can return on growth trajectory soon. A series of recent ominous developments provide platform for business avenues. Firstly, rupee-dollar parity has undergone 35% depreciation since Oct’08 and has remained relatively stable after deregulation by SBP. Compared to regional competitors like India and China, Pakistan enjoys a comparative advantage to European and Middle Eastern markets. Secondly, higher cotton crop has caused a decline in costs and increment in margins for textile sector. Amidst a growing global demand and favorable exchange rate, cotton and textile exports can lead revival of manufacturing in Pakistan. This provides banks with an opportunity to refresh financing lines for working capital and gain from textile sector expansion. Thirdly, consumer financing has gone through consolidation and is now subject to a comprehensive regulatory framework. As domestic asset prices have stabilized, their demand could be reignited by stimulating consumer business like autos, home appliances and house financing. This will not only provide a broad based market for banking products but initiate growth in construction, electrical, automotive, materials and related industries in Pakistan.