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Prospects and challenges in banking industry.

Preamble: The banking system of any economy is an undeniable determinant of its growth as it provides an efficient channel that routes funds from surplus sectors in the economy towards deficit ones. During the last decade, the banking sector has gone through a number of changes. The reforms have been implemented in the context of a broader macroeconomic stabilization and structural agenda, providing an essential foundation to financial sector recovery. A major achievement of the reforms process has been the transformation of a primarily state owned and weak banking sector into a healthier market based system, owned by the private sector. This has been facilitated by the restructuring of major banks, ongoing consolidation of the sector through mergers and acquisitions, strengthening of the regulatory regime, and improvements in transparency, corporate governance and credit culture.

An overview of banking sector

The commercial banking sector in Pakistan has come of age and is now well equipped in terms of technology, skills and financial resources to play an effective role in financial intermediation. A few words on the financial sector's scope and scale:

Financial assets grew by 70 percent over the past five years and in CY05 reached Rs. 5.1 trillion ($ & 1billion), equivalent to 80 percent of GDP.

The banking sector grew at a faster pace relative to non-bank sectors and accounts for 71 percent of the financial industry assets.

Banks have aggressively increased their lending portfolios in the recent years with their gross advance percent i.e. from Rs 1.63 trillion in FY04 to Rs 2.05 trillion during FY05. The share of consumer financing in the overall credit portfolio stood at Rs. 213.8 billion during CY05: from Rs. 122.4 billion recorded during CY04, depicting a quantum jump of 75 percent.

Total deposits of all commercial banks stood at Rs. 2.83 trillion at he end of CY05 as against Rs. 2.39 trillion during CY04 i.e. an increase of over 18 percent.

Banking sector profit (after tax) of Rs. 63.3 billion in 2005 is at an all time high surpassing the profit of Rs. 34.7 billion in 2004. Resultantly return on assets increased appreciably to 1.9 percent from 1.2 percent in CY2004, which is comfortably above the relevant international benchmark.

Capital adequacy ratio (CAR) improved to 11.3 percent in 2005 from 10.5 percent in 2004 showing strengthening of the system.

Non-performing loans declined by Rs. 22 billion resulting into a decline in NPLs to loans and, net NPLs to net loans ratios to 8 percent and 2.1 percent respectively, indicating receding threat to the financial soundness of the system.

M2 (broad money) has touched the figure of Rs. 3.41 trillion as on June 30, 2006 showing an increase of 14.54 percent over Rs. 2.96 trillion as on June 30, 2005. This represents additional liquidity of almost Rs. 451 billion available with the banks. Out of total M2 growth of Rs.451 billion, over 88 percent or Rs. 399 billion was contributed by the increase in the Net Domestic Assets (NDA) of the banking system. Net Foreign Assets (NFA) on the other hand increased by Rs. 52 billion approximately as the payment for imports kept the money supply from foreign inflow (remittances and privatization proceeds) in check.

Eighty percent of banking has now come under private management and the already competitive environment has become even more intense. Benefiting from the continuing consolidation process in large banks and the cautious stance of foreign banks, medium-sized private banks have managed to expand their operations vigorously. This has largely been due to continuing improvement in service quality and the expanding geographical outreach.

As at the end of CY05 the banking sector provided employment to 85,469 people (CY04: 81,759) and operated a network of 6,858 branches (CY04: 6,584). In other words, as many as 274 additional branches were opened and 3,710 more jobs were created by the banking sector during CY05.

With advancement in the IT infrastructure of banks, electronic banking also witnessed a considerable growth. Number of on-line branches increased to 3,265 during CY05 as compared to 2,897 during CY04. Similarly, 7.94 million AT transactions were carried out at1, 217ATM's during CY05 involving an aggregate sum of Rs. 46.7 billion.

With declining spreads in corporate finance, banks are increasing their focus on other segments, principally the SME sector and consumer finance. While this shift is expected to preserve declining margins, it also exposes the banks to higher levels of risk. The increase in risk appetite would obviously require more stringent risk management systems for preserving asset quality. While there is a general improvement in risk management systems across the banking sector, there is less than adequate sensitivity about ensuring that the risk appetite remains consistent with the capacity of individual banks to manage it.

Regulatory reforms in the banking sector

In this regard, the role of the regulators (SBP) has been critical. In recent years, SBP has demonstrated its commitment and capacity not only at ensuring consolidation and orderly growth in the banking sector, but also introduction of effective risk management policies. Under the active supervision of the SBP, the financial soundness indicators of the financial system have strengthened substantially which include robust profits, strengthening of capital base and declining overhang of non-performing loans. In order to further consolidate these achievements the SBP has rolled out a Strategic Plan 2005-2010. For this purpose the following measures and developments are underway:

Adoption of Basel II: One of the objectives of these reforms and guidelines is to build up internal capacity of the banks for Basel II Accord, which the central bank intends to implement by January 2008. In line with this, the SBP is proposing changes to the applicable regime of minimum capital requirement--the Capital Adequacy Ratio--to include capital change for market risk, which comprises interest rate, equities investment position and foreign exchange risks. The market risk capital requirement would be calculated separately.

Variable Capital Adequacy Ratio (CAR): It will be based on the rating assigned by the Institutional Risk Assessment Framework (IRAF) to each bank depending upon its financial condition. This implies introduction of a more sophisticated risk-based approach.

Strengthening of Capital Base: All banks ate required to gradually raise their minimum capital to Rs 6 billion by 2009. This would help promote consolidation in the banking system through mergers, as weaker banks would find it difficult to survive in the emerging scenario.

Strengthening of Risk Management Framework: The State Bank has also issued detailed risk management guidelines, which elaborate procedures for identifying, measuring, monitoring and managing credit, market, liquidity, country and operational risks. The SBP, being cognizant of the importance of a properly designed and implemented internal control system for an adequate risk management framework, has issued guidelines on internal controls. These guidelines elaborate upon the different elements of an internal control system and provide guidance for its implementation, evaluation and reporting. Responsibilities of key players are also highlighted, particularly with regard to the responsibility of Board of Directors for ensuring efficient internal control system. For an adequate risk management framework has guideline elaborate upon the different elements of an internal control system and provide guidance for its implementations, evaluation and reporting. Responsibilities of key players are also highlighted, particularly with regard to the responsibility of Board of Directors for ensuring efficient internal control system. Banks are required to submit half-yearly progress reports regarding the status of compliance with the guidelines.

Stress Testing: Financial system is normally exposed to different types of risks like credit, market, interest rate risks. Stress testing is one of the most widely used techniques to determine the likely situations of financial distress. SBP has addressed this issue and has done stress testing, taking various scenarios in its study. The analysis suggests that the banking system could withstand shocks resulting from the losses accumulated without deteriorating the capital of the banks.

Transparency and Disclosure Requirements: These have been made further stringent to keep the stakeholders fully abreast with the financial profile and developing risks within the financial system. The risk management systems within banks have improved significantly. The greater disclosure requirements and strengthened corporate governance structure have helped promote transparency, which is expected to prevent banks from committing serious mistakes. Moreover, the latest amendments to the Prudential Regulations with regard to the classification and provisioning of NPLs have allowed more transparent reporting of infected portfolios by the banking sector.

Revamping of Credit Information Bureau (CIB): The CIB has gone online and minimum limit of Rs. 0.5 million for data reporting has been removed. This will help the banks to examine the credit profile of those customers, which remained outside the ambit of CIB. This will help capture the risks originating in the consumer and SMEs sectors, which have absorbed significant funds from banks in recent times.

Amendments in Prudential Regulations: The prudential regulations were mainly aimed at corporate and business financing. A new set of regulations has now been developed which caters to the specific needs of corporate, consumer and SME financing. During the year, prudential regulations for agricultural financing have also been developed, besides bringing some refinements in the already issued prudential guidelines.

Challenges Despite the above-mentioned qualitative changes in the operations of the banking system, the sector is still faced with a number of key issues and challenges. Some of them are:

(i) Pakistan's financial sector is still not diversified enough, as a major portion of the economy is still not monetized.

(ii) Anumber of players in the market are undercapitalized and may face serious difficulties in timely compliance of SBPs recent requirement of increase in paid-up capital to Rs. 6 billion by December 31, 2009 failing which the bank will be converted into a non-scheduled bank with restricted activities or merged with other bank.

(iii) Despite all the fanfare and media' blitz, agriculture, SME's and housing sectors are still underserved and have limited access to credit.

(iv) The retail-banking model, which is in fashion these days, demands a comprehensive branch net work. Apart from raising depos its at lower costs, the key issue in the future banking model would be the distribution of retail product

(v) Liquidity hang over is still persisting compounded with scarcity of lucrative money deployment opportunities.

(vi) Additionally, the management of potential investment/portfolio losses is also likely to be a key factor affecting the performance of the banking sector in the short to medium term.

(vi) Low credit penetration ratios.

(vii)Inadequate human resources.

Prospects Going forward, performance prospects of individual banks would continue to remain a function of a number of bank-specific variables. The as set size of the bank, its geographical outreach, the financial standing and credibility of bank sponsors, the quality of human resource and technological base are all key elements, which would impact on performance prospects.

The relatively smaller banks, which might not have succeeded in developing specific market niches, would continue to fight for survival and might well become candidates for acquisition by or merger with larger banks. The medium size banks have already come out successfully in the fast evolving competitive environment, and seem well placed for sustaining their performance and asset quality. However, they continue to face the threat of greater competition from the privatized large public sector banks like HBL and UBL. There is, thus an increasing awareness that in order to maintain their historic performance, they have to remain committed to continuous improvement in service quality as well as product innovation. These factors would inevitably lead to greater efficiency in financial intermediation and provide a wider range of choice to banking customers.

As recently stated by the SBP Governor at a speech delivered at the Adam Smith Institute at Thun, Switzerland, on June 27, 2006, Pakistan is now embarking on the next phase of financial sector reforms which would focus on:

* Further consolidation and restructuring of the banking sect

* Strengthened risk management;

* Developing capacities to cater for unmet requirements of special segments of the economy and diverse needs;

* Diversification of the financial sector by further development of the securities and debt markets, which while fairly vibrant, need to play a more significant role in meeting the country's financing requirements; and

* Promoting financial product in novatio


Although banking sector has witnessed tremendous growth in profitability in the recent years owing to growth in advances, increasing net interest income and reduced tax rates, among others, yet banks have to customize, their operations to remain competitive, especially in the light of growth expected in the mutual funds industry. There is increased competition for market share especially, in the wake of Government's recent decision to allow the Directorate of National Savings to also accept corporate deposits and SBPs latest increase in the cumulative SLR & CRR requirements from 20 percent to 25 percent.

Moreover, expanding business activities of the private banks, reentry of foreign banks, strict regulatory and disclosure requirements, increased minimum paid up capital requirements, implementation of Basel II, modernization of core banking systems, increased automation and up gradation of IT and development of new products shall have a significant impact on banks resources. Only efficient banks with competent management, a reasonably large network and with agriculture and consumer/SME focus should excel in the future banking industry scene.
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Author:Khan, Hamesh
Publication:Economic Review
Geographic Code:9PAKI
Date:Nov 1, 2006
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