ARTICLE (May 06 2010): Financial statements for 2009 indicate that Pakistan's banks have successfully weathered the immediate after-shocks of the previous year's global financial storm. Fortunately, our banks never had direct exposure to the crisis, thanks to prudence by the State Bank, which disallowed (and still does) institutions under its charge from investing in overseas debt markets, despite the high returns promised by derivatives instruments.
The five major banks (NBP, HBL, MCB, UBL, ABL) have made healthy profits, in total Rs 62 billion, reflecting an average return of 18.75% on equity, with earnings at 1.4 times the par value of each share. Retained earnings for the past few years, supported by adequate provisioning, enable the banking majors to maintain excellent capital adequacy ratios, averaging above 15%.
The picture is not so rosy for banks in the next tier, where the higher pro rata exposure to retail and consumer loans has required massive write-downs. These organisations are still reeling from the triple shocks that jolted the domestic economy in 2008 through the stock exchanges collapse, the spike in dollar prices and failure of the Dubai property market. Their average return on equity is 2.3% with earnings per share averaging 10% of par value.
What is noticeable is that banking profits have not emanated from cost efficiencies, innovative services or investment in new products and markets, but through higher spreads (average lending rates were 17% for the majors, 22% for the next tier, Citibank topping with 36%!) that have squeezed the profitability and increased the vulnerability of their customers, while contributing to lower investment and higher unemployment in the economy. In this respect, our banks have achieved undesirable commonality with their peers in developed countries, ie there is a clear disconnect between the health of banks and health of the economy.
Results announced for first quarter January-March 2010 reveals that bank profitability is being sustained, which is comforting, but that the profits are still coming from high lending rates. This is not good. Instead of waiting on the State Bank to lower the discount rate, banks should feel confident, possessing resources and reserves, to lower their spreads, thereby providing much-needed stimulus for the business growth of their customers.
They need to turn their attention also to risk areas where mitigation does not lie in higher spreads, but in pro-active initiatives and change of mindset, both to strategize increased and diversified credit as the driver of growth and to confront issues that impair the banking sector's freedom of action. Some issues are identified here.
First is risk concentration - sector-wise lending in Textiles and Energy claims 25% to 30% of the top banks' lending portfolios, while segment risk is concentrated on corporate lending, topping 60% for most banks. The sector and segment risks are intertwined, textiles and energy companies are also the major corporate borrowers, the prospects for both are not good.
In the case of textiles, the reason for its problems is management inefficiency, rather than market conditions or cost-push factors; therefore, continuing to throw good money at bad managers is not a sound proposition. As for the power sector, although there is no denying the growth prospects, the Rs 200 billion inter-corporate debt is a current risk not only for the companies involved but also their lenders. The money may be safe but it cannot be unblocked and danger lurks because both textiles and power sector loans are fast reaching a stage where debt servicing will become a problem, if it is not one already.
Second, the banks need to address the potential for liquidity squeeze. One of the causes of the 2008 global financial crisis was that the affected banks paid too much attention to capital adequacy ratios and too little to liquidity risk. The same applies In Pakistan today, with banks enjoying healthy capital ratios but loan exposure to corporates in general and the textiles and energy sectors in particular (this exceeds Rs 800 billion in the top 10 banks) can create severe liquidity problems across the financial system.
Third, customer loan concentration - as the financial reports do not disclose loan segmentation by number of customers, one has to go by a 2007 State Bank report which noted that bank lending in Pakistan remained highly unbalanced: out of 5.5 million borrowers, less than 25,000 entities accounted for 70% of the loan book and less than 60 groups accounted for 30% of all lending. This credit monopolisation results in the banks being held hostage to a clique of vested interests, whose financial power enables them to nullify efforts towards broad-based lending and leads to a speculative economy in which manufacturing, new project and SME activity, in particular, remain starved of funding.
Fourth is non-compliance with global regulatory standards - two months ago Pakistan was placed on the watch list by the Financial Action Task Force (FATF) for failure to comply fully with Anti-Money Laundering procedures, which came as a surprise, considering that bank auditors since 2007 have been signing off their clients as being fully AML compliant. Similarly, banks remain behind schedule in adopting Basel II-mandated measures for risk mitigation and developing internal capital adequacy processes (ICAAP.)
Consider the cost of not complying. Pakistan's international trade plus current account and services transfers are in the region of USD 60 billion. The lower ratings generated by FATF blacklisting and lower Basel II compliance translate into higher risk premia that counterparties attach to financial transactions with Pakistan. Assuming a conservative half percentage point as additional premium, the cost of this lack of compliance is USD 300 million annually, ie Rs 25 billion, being borne by business in Pakistan.
The fifth area of concern is capacity-building - modern banking is a technology-driven, people intensive business. A bank is only as good as the skills of the people who manage it and as safe as the information available to those who supervise its managers. One of the factors behind the overseas 2008 financial crisis was the inability of senior management and Boards to understand the mathematics that created the products or the technology that drove their banks' processes.
Such disconnect exists also in Pakistan and banks would be prudent to move quickly to close this skills gap. Being on the FATF watch list is result of inadequate training in AML procedures; similarly, the collapse of the consumer lending portfolio may be traced largely to the absence of training among managers to deal with adversity in this otherwise highest profit area for banks.
Basel II compliance is a complex and continuous process, which stresses training not only for banks to achieve the desired risk mitigation competencies but also for regulators, for supervising risk controls to ensure that banks arrive at the prescribed milestones through a robust training regime.
Sixth is Section 27 B of the Banking Companies Ordinance - Senator Rabbani's ill-considered initiative to repeal this legislation, which prohibits union membership to non-employees and other undesirable activities, may have been deflected by the business tycoons who dominate the Senate Banking & Finance Committee, but it threatens to come back through the National Assembly, where the business lobby is not so strong. The banking industry, with SBP backing, needs to remain vigilant to ensure that this highly contentious move does not become a risk element for the entire industry.
Seventh are new additions to the Banking Ordinance, which propose wide powers to the State Bank to intervene pro-actively in Bank management affairs. On the surface, they may be genuinely motivated for shareholder protection, in practice they can become a tool for political intervention in bank affairs and, combined with repeal of Section 27-B, would present the country with a return to the pre- 997 situation that saw the banking system crippled and on its knees.
In conclusion, it is noted that while the future, as always, poses uncertainties, the risks perceived by banks in 2008 are no longer the principal areas of concern. The banks need to move on, to exit from the cocoon of high spreads towards improving the health of their customers as a necessity for keeping themselves in good health. A satisfied and loyal customer base will create banks need to effectively protect the banking system from what appears to be a looming political assault on its independence and integrity.
(The writer is a management consultant)
Source: http://www.brecorder.com/index.php?id=1053010&currPageNo=1&query=&search=&term=&supDate=
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