Challenges facing the banking system.
The challenges facing the banking system in Pakistan in the current economic environment are now more than ever linked to the more broad and macro economic challenges facing the economy. The financial services business, in my opinion, will have to play a far more critical role in the post-nuclear situation as it needs to contend with how to meet the competing needs of industry, trade and government in a volatile resource constrained and unpredictable environment, compounded by the adjustment to a completely new set of regulations representing a dramatic departure from the past and in the absence of significant capital raising from debt and equity. If you add to this very difficult environment the structural issues that have plagued the banking system, particularly the nationalized banks, over the last few years, for example loan defaults and the high cost of financial intermediation, you can very quickly see that the task is truly gigantic and therefore needs extremely critical and careful attention. In many respects, the financial sector over the last 18 months has been strengthened by the induction of professional management at the NCBs and DFI's, a concerted effort at loan recoveries which is beginning to bear some fruit and a focus on the customer services. Profits for foreign and private banks have been attractive because of the FC deposit scheme and the increase in cross border trade Liquidity and interest rates have till recently been stable and the last have also seen credit cards, the emergence of a corporate bond market as well as international capital raising. However, the new realities will undoubtedly impact the situation. I believe there are three principal issues facing the financial services business today:-
2. Risk and Portfolio Issues;
3. Impact of the macro economy.
Liquidity in my opinion is the single most critical issue today facing the banking system. Without going into the pros and cons of the foreign currency deposit scheme, it is clear that since 1991, the banking system's liquidity was very substantially boosted by the scheme. From a paltry 2 per cent in 1991 prior to the government allowing resident foreign currency deposits, on May 28, 1998 it is estimated that almost 47 per cent of the total deposits in the banking system were dollarized - an alarming increase. In any event it was on the back of this scheme that the foreign banks appreciably increased their balance sheet footings and since through the subsidized forward cover fee the overall cost of deposits to the banks was between 12 and 13 per cent money was made available to trade and industry at a relatively low real interest rate. The scheme also in some cases encouraged borrowing for speculative purposes or for hedging foreign currency exposure. All of this was made possible by the inflow of between $1-1/2 to 2 billion through the informal sector and whereas the government through the relatively cheap forward cover fee was paying a fairly large fiscal cost, the scheme besides increasing liquidity in the banking system was enabling the government to add to foreign exchange reserves at a very subsidized cost, i.e. either at Libor or 25 basis points above Libor. I do not want to digress by debating whether the scheme was properly managed or not. A retrospective evaluation is always much easier. However, what is clear is that after the freeze on the foreign currency accounts and the government's very clear and stated desire that account holders should convert their foreign currency into rupees liquidity from the banks is going away at an alarming rate. The recently announced dollar bonds will exacerbate the problem if arrangements are not in place to allow the banks to access the liquidity created through the bond purchases. Statements coming from senior government functionaries to use the converted rupees for purchasing government securities is further complicating the liquidity threat to banks. The only alternative that banks have to counteract this haemorrhage is to offer rupee products at rates which at least match the rates offered by the national savings scheme, i.e. an after-tax return of 16-1/2 per cent. Thus, if a bank's' marginal cost of funding 16-1/2 per cent, it is clear that borrowing rates will have to be at least 300 to 400 basis points above this level raising the entire interest rate level threshold in the economy. This, of course, has serious implications for GDP growth.
It is therefore clear that the dollar freeze and its subsequent implications will have a substantially detrimental impact on all those banks whose funding was primarily dollar based, i.e. the foreign banks and the private banks in particular, but also on the system as a whole. The substitution of institutional deposits from overseas banks to counteract the reduction in dollar deposits is in the current environment a very difficult proposition given the perception of Pakistan risk. It is also evident that if the assets of banks are more in loans than in government securities (which are liquid and easily realizable), this will further compound the liquidity issue since loans cannot be easily rundown. And whereas it is gratifying to hear that the State Bank has on a number of occasions assured the banking system that it will make available liquidity for crisis needs, no financial institution can have a viable base if it continues to rely on a central bank liquidity bailout. This problem of liquidity is confined not only to the commercial banks but also to investment banks and the leasing companies. lt is therefore asystematic issue. The new dollar schemes are not expected to bring in any large volumes because of the basic breakdown in confidence. In my opinion, I believe that they may in fact pose further hazards for some banks, particularly the smaller banks who may start offering unrealistically high deposit rates and consequently having no alternative but to invest in high risk areas.
As a result of all these factors, financial institutions have to focus much more closely on funding and balance sheet management and given the very difficult choices involved, there is a risk that some institutions might not survive independently. I also want to add that the dollar bonds potentially carry a very substantial fiscal risk for the government. Depending on the quantity of bonds created, in 5 years time since the bonds are dollar-based, the government may end up paying a huge rupee differential depending on what the rupee/dollar rate is in 5 years to redeem a dollar obligation. It is therefore a sword of Damocles that will continue to hang on the head of the country's finance managers and will vastly, vastly comparised the already unbelievable debt something problem.
Turning to credit risk issues, I believe that the adverse impact on a number of sectors of the much more restrictive foreign exchange regime and the associated high er costs will create even more pressures on bank portfolios. The ability of institutions to withstand these pressures depends on the capital and reserves levels as well as their credit management processes. All financial institutions will face portfolio deterioration, some more than others. Do all the smaller banks have the ability and depth to withstand these strains? It is difficult to tell at this stage. The issue of liquidity and credit risk is further compounded by the revenue crunch that all financial institutions in Pakistan are facing today. Letters of credit of Pakistani banks are not easily accepted in the international market and if they are, it is only at a very substantial cost. This means that revenue from trade finance, a core area for all commercial banks in Pakistan, will show appreciable diminution. I have already referred earlier to the higher funding cost which will further drag revenue downward. With little in the way of product innovation possible in the current environment, bank earnings are bound to reduce. International capital raising will become extremely problematic given the perceptions of Pakistan cross border risk as reflected in the downgrade by the rating agencies.
Many institutions, particularly the investment banks who have large investments in the stock market, will be forced to mark their asset portfolios at the current prices. This will impose an additional strain. On the other side costs continue to increase because of technological investments and inflation. Banks will have to re-engineer or reconfigure to achieve cost efficiencies and reductions. Jobs are not expected to increase.
Another very relevant external consideration that will impact the Pakistani banks is the international requirement of capital adequacy standards at roughly 8 per cent. The nationalized banks fall short of this ratio and whereas improvements have taken place in the last couple of years, given the difficult environment, it might not be very easy to achieve this level. The issue of size is also becoming an international standard. For example, banks with a capital size of less than $100 to 150 million are not considered internationally to meet the minimum critical size required. Unfortunately, many of the smaller Pakistani banks while having decent balance sheets are much below this critical size. If these institutions want to deal internationally, I do not see how that is possible unless some kind of consolidation takes place.
The environment for investment banks is just as daunting. With capital raising almost non-existent and with the stock market at an all-time low, their balance sheets will be severely impacted. It is possible that the investment banks will be looking at alternatives, possibly exploring the option of converting into commercial banks to meet their financial objectives. The aggregation of the above sums up the challenges facing the financial services industry in Pakistan today. Much of the future of the industry depends on the .performance of the macro economy which in rum is related to external events over which the banking industry has no control.
Finally, after this rather depressing evaluation, let me say that on the slightly brighter side Pakistan's financial sector has been insulated from a number of issues that have been at the core of the problems in the Southeast Asian countries. For example, lending for property and equity speculation. Also, currently Pakistan's total ban king assets to GDP ratio at 25 per cent is amongst the lowest in the region, comparing with 50 per cent for Thailand and almost 70 per cent for Indonesia and Malaysia. It also has to be said to the credit of the central bank that the Prudential Regulations in the last few years have buffered the overall health and stability of the banking system and in many ways has provided it with at least a base and hopefully the ability to confront the future.
To sum up, the challenges are tremendous, but the structural reforms if instituted properly should enable the banking system to sustain these challenges going forward. The lessons of the last few years, particularly from Japan, the Far East and Mexico, should make us realize that the health of the financial sector is probably the single greatest indicator of the health of the economy.