6  The Banking Sector

 

6.1 Overview

 

Table 6.1: Changes in Selected Banking Sector Indicators

 

The banking industry turned in an exceptional performance for the second successive year in FY03, leveraging on a spectacular growth in deposits, aggressive marketing and investments, and increased efficiency, to counteract the impact of a sharp decline in interest rates. As a result, not only did the profitability of the sector increase, but selected industry indicators also depicted major improvements relative to the preceding year (see Table 6.1). In addition, the industry took important strides in improving governance, the furtherance of Islamic banking, and towards the privatization of government owned-banks.

 

The deposit growth is particularly impressive given that it comes on the back of the already strong double-digit increases in the last two years. To put this in perspective, in absolute terms, the FY03 increase in deposits is almost equal to the sum of the rise in the preceding two years.

 

Not surprisingly, the strong deposit growth together with the easy monetary stance of the SBP contributed to a sharp decline in domestic interest rates. Two developments, in particular, marked a striking change from the recent past: (1) the November-2002 discount rate cut pushed T-bill yields to all-time lows; and (2) for once, lending rates responded strongly to the decline in T-bill rates, with the weighted average lending rate dropping into single digit for the first time in nearly thirty years.

This large reduction in interest rates finally initiated a resurgence of credit demand, taking the FY03 net credit expansion to a phenomenal Rs 133.2 billion, over three times higher than the corresponding FY02 figure. While a part of the higher FY03 credit probably reflects the exploitation of interest rate arbitrage available through NSS instruments, evidence clearly points to a strong contribution of increased economic activity as well as the aggressive marketing of consumer credit by the banks.

However, the pressure on banks' management to maintain profitability under the twin impact of falling return on assets and increasing liquidity has led to concerns over the quality of banks' asset portfolio and earnings for FY03. In particular, banks generated a substantial portion of their earnings through non-interest income, including capital gains on equity investments and fixed income securities.

 

6.2 Policy Environment

 

On policy issues, while the SBP focus remained unchanged at strengthening of the supervisory and regulatory framework, instilling a competitive business environment both by promoting the role of the private sector and liberalizing the financial markets, and to improve financial health of the banking sector; significant progress has been made during FY03. Key developments are analyzed below.

 

6.2.1 Privatization of Public Sector Banks

 

Privatization of public sector banks, which was initiated in the early 1990s, gathered pace during FY03. In particular, October 2002 saw the privatization of UBL, one of Pakistan's largest banks, as the government divested a 51 percent share in UBL to a consortium of investors, comprising the Abu Dhabi Group & Bestway Group. Consequently, the share of domestic private sector banks in the aggregate banking assets has now risen to 43.5 percent (see Figure 6.1).

 

In addition, the government divested yet another 10 percent stake in a second large bank, National Bank of Pakistan1 during October 2002, as well as its remaining shares in a third large bank, Muslim Commercial Bank. Moreover, the process for the privatization of another large institution, Habib Bank Limited, is also well underway; the Privatization Commission has already received the Expression of Interest (EOT) from investors interested in the acquisition of minimum 26 percent stake.2

Finally, the Privatization Commission has also requested SBP to make arrangements for the dis­investment of the government's remaining 49 percent share in Allied Bank of Pakistan Limited. The SBP has received Expression of Interest (EOT) from 12 prospective bidders, of which nine have been short-listed and asked to provide Statements of Qualification.

 

6.2.2 Islamic Banking

 

In a bid to comply with the verdict of Shariah Appellant Bench of 1999, SBP had issued detailed guidelines for the establishment of Islamic Commercial Banks with effect from December 1, 2001. A license under these guidelines was issued to Meezan Bank Limited (as a model Islamic Bank in Pakistan) for the commencement of Islamic banking business in January 2002.

 

Additionally, in November 2002, the Banking Companies Ordinance (BCO) 1962 was amended to implement the process of Islamization of the financial system in parallel with conventional banking.3 Following these amendments, detailed criteria for the establishment of Islamic Commercial Banks, and Islamic Banking Subsidiaries and/or Stand-alone branches for Islamic banking by the existing commercial banks was issued vide BPD Circular No. 1 dated January 1, 2003.

 

Following the issuance of these guidelines, five banks applied for permission to establish stand-alone branches for Islamic banking, leading to the issuance of the first Islamic Banking Branch License to MCB in May 2003; this branch has started commercial business, while applications of other banks are under consideration.

 

6.2.3 Strengthening of Supervisory System

 

In an effort to have a clear demarcation in supervisory responsibilities of SBP and SECP for the regulation of financial institutions, amendments in BCO 1962 were made in November 2002. Subsequently, the supervisory and regulatory responsibilities of all NBFIs, except DFIs, were transferred to SECP from SBP in December 2002. Since this demarcation calls for better coordination between SBP and SECP, quarterly meetings between senior management of the two regulatory authorities have been made mandatory.

6.2.4 Prudential Regulations

 

The following FY03 changes in prudential regulations are particularly notable:

 

•         To safeguard the interest of prospective investors, depositors and creditors, credit rating requirement for banks have been made mandatory vide a BPD circular No 9 dated May 3, 2002. Banks have been asked to get themselves rated by the SBP approved credit rating agencies; this is to be an on-going process and the rating is to be updated annually. The time period allowed for the process of credit rating has been increased from four months to six months.4

 

•         To promote good corporate governance and to encourage senior management (Presidents/Chief Executives and Board of Directors) to play an active role in capacity building of the institutions, revised guidelines under "Fit & Proper Test" have been issued with effect from November 30, 2002.

 

•         To prevent the possible use of banks for money laundering, terrorist financing and other illegal activities, the SBP has issued "Know Your Customer (KYC)" guidelines for the due diligence of customers with effect from March 29,2003.

 

6.2.5 Non Performing Loans

 

Since 1997, SBP has been following a multi-pronged policy in order to manage the burden of NPLs of the banking sector. Major steps include clear guidelines for the classification of NPLs and provisions required there against; establishment of the Corporate and Industrial Restructuring Corporation (CIRC); Committee for Revival of Sick Industrial Units; and prosecution of defaulted cases under NAB Ordinance. Additionally, banks were pressured to accelerate recoveries.

An important development in FY03, in this regard, was the release of new guidelines for the write-off of irrecoverable loans and advances.5 These guidelines are designed to help banks to settle their old NPLs in an orderly and transparent manner. Write-offs/waivers under these guidelines force banks to account for the erosion in the values of assets carried on their balance sheets as a part of asset receivables (for details see Box 6.1).

 

6.3 Banking Sector Developments During FY03

6.3.1 Deposits of the Banking Sector

 

Despite offering negative real rate of returns on deposits, the banking sector recorded double-digit deposit growth for third year in a row, primarily on the back of a continuing improvement in the country's external account. Specifically, the remarkable 19.5 percent FY03 deposit growth, amounting to Rs 275.1 billion, was primarily driven by exceptional growth in remittances (see Figure 6.2). In fact, the bank-wise distribution of workers' remittances showed that around 80 percent of remittances were remitted through 10 banks, which also accounted for 70 percent of the aggregate deposit growth of the banking sector. However, unlike the preceding year, it appears that the FY03 deposits growth also incorporates a significant contribution from improvements in the domestic economy. The latter appears to stem from increased profitability of the corporate sector and impressive earnings of the agriculture sector.

 

Interestingly, it appears that increasing e-banking activities, use of ATM in particular, may have significantly affected the cash preferences of the public, as the cash holding in the economy has declined during FY03 (see Special Section on e-Banking). This is also evident from the fact that the rise in currency in circulation was substantially lower despite a substantial growth in reserve money.

 

As a result, currency to deposit ratio has decline

 

A distribution of the deposit growth by bank groups6 reveals that domestic private banks led the field in FY03, mobilizing Rs 195.7 billion (see Table 6.2). A part of this

performance is explained by the merger/acquisitions of some foreign banks with private banks, but even after adjusting for these, the aggregate growth in the deposits of

private banks remains impressive at 28.3 percent. This robust deposit growth of private banks is probably driven by the relatively higher rate of return on deposits offered by these banks and increasing branch network.