The remarkable resilience of Pakistan's banks

Pakistan is a country confronting a range of daunting challenges. Embroiled in a war on its lawless north-western border with Afghanistan, Pakistan has experienced a dramatic deterioration in its domestic security in recent months - a situation that is not helped by ongoing political instability. These severe problems, combined with the global financial crisis and the subsequent worldwide economic slump, have taken their toll on government coffers.

Following a surge in food and fuel prices in the middle of 2008, which pushed headline inflation up to 25%, the country entered a downward economic spiral in the latter half of that year. As its trade and budget deficits ballooned out of control, Pakistan was forced to seek assistance from the International Monetary Fund, which granted the country an $11.3bn credit facility under a 25-month stabilisation programme. Although the programme has enjoyed some progress, fiscal consolidation continues to be adversely affected by low economic activity - particularly in the country's badly hit manufacturing sector - and the challenging security environment.

While inflation has fallen overall, it remains bumpy, although the country's gross domestic product is moving in the right direction and is forecast to reach 3% and 4% growth for 2010 and 2011, respectively. "We have weathered the initial thrust of the economic storm but there is more hard work to be done," says Sibtain Fazal Halim, secretary of the Pakistani government's economic affairs division.

To make matters worse, the country is in the midst of a severe energy crisis. Load-shedding (intentionally cutting off power) extends for 15 to 16 hours a day, badly disrupting industrial production and operation. In the view of many leading commercial figures, the energy crisis represents a more devastating blow to the economy than the country's far more high-profile security problems. "I would say that the impact of the power crisis is bigger today than that of terrorist activity," says Badar Kazmi, CEO of Standard Chartered Bank Pakistan.

Private sector slump

Against this testing backdrop, Pakistan's banking system has remained remarkably resilient. But the broader economic environment combined with the power crisis, political instability, security concerns and high interest rates have served to dampen private-sector investment and borrowing dramatically, report bankers.

"Because of a combination of political and economic factors, there has been very little credit off-take," says Sirajuddin Aziz, CEO of Bank Alfalah. "We haven't seen any increase in our loan book - in fact, it's been static."

According to ratings agency Moody's, private sector lending in Pakistan shrank by about 8% last year, and bankers report that this reflects both an unwillingness among banks to extend credit and a lack of desire for credit among the country's major corporates. "Organisations are generally being very conservative: they are preserving cash and paying dividends," says Arif Usmani, country officer for Citi Pakistan.

For the larger local banks the picture is not so gloomy, however. At the state-owned National Bank of Pakistan (NBP), the country's largest lender, for example, things are starting to pick up. "We have seen evidence that private sector growth is picking up and we're looking at a number of new projects in infrastructure, textiles and other [sectors]," says Syed Ali Raza, president of NBP. "Last year there was very little in the way of new investment coming in, but now we are seeing a desire among companies to expand." The bank is looking at putting together some public-private-partnership infrastructure financing, he adds.

If the private sector has proved a reluctant borrower, the public sector has proved exceptionally credit-hungry - to the extent that many market-watchers have accused the government of effectively marginalising the private sector. "In 2009, the government was crowding out the corporate sector by borrowing very heavily itself," says Mr Aziz. "Most of the banks that mobilised resources put them into government securities." The banking sector's ever-expanding exposure to the government, through a surge in the purchase of relatively low-rated treasury bills and lending to government commodity subsidy agencies, is a worry for some analysts.

By October 2009, lending to the private sector had reached a staggering growth rate of 63%, according to data from the State Bank of Pakistan (SBP) cited by Moody's. About 18% of total system assets were invested in government securities, as of the end of September 2009, according to Moody's estimates. More recent figures are not available but public sector lending did decline in the first quarter of 2010, although analysts are still wary.

"Banks are generally very willing to lend to commodity subsidy financing. They consider it to be risk-free as [they are lending to] the government but, if the government has problems paying the subsidies, there could be potential for a debt arrears problem," says Christos Theofilou, an analyst at Moody's.

Historically, the government has not always met its obligations on time, and during the past six months the banking sector's high concentration of government exposure has served to dampen ratings. Despite the government's constrained finances, however, Mr Raza dismisses this exposure concern. "It's unlikely the government would default on local currency debt," he says. "Yes, there has been more funding of government agencies through the banking system than in the past, but it's not alarming."

Even so, asset quality is moving in the wrong direction. Non-performing loans (NPLs) as a percentage of gross loans have jumped in recent quarters to about 12% of system-wide assets, a deterioration brought on to a large extent by high interest rates. "Banks are now groping with the challenge of ensuring that the asset book issues they face are managed," says Mr Kazmi, although NBP's Mr Raza counsels against panic on asset quality. "It is not alarming but it's much higher than it used to be," he says. "The smaller banks are impacted more by NPLs, and it is largely in the consumer portfolio."

Syed Ali Raza, president of NBP

Consumer calamity

Indeed, most banks are still smarting from the explosion of delinquencies in the industry's consumer lending portfolio. The majority of consumer products in Pakistan, including mortgages, are priced at a variable rate. As interest rates rose, many assets fell into distress between early 2008 and the end of 2009 as the burden of servicing their debt became too great for many Pakistanis to bear.

But the precipitous increase in interest rates only exacerbated problems created by poor consumer risk-management practices, which did little to rein in an aggressive industry-wide push into the extremely immature consumer segment. "Banks went into consumer lending without having the right infrastructure in place to supervise a retail portfolio," says Mr Theofilou. "As a result, they've had trouble in this area."

To expand quickly in the absence of an extensive branch network, many banks hired roving sales agents to seek out and sell to individuals already borrowing from the first-movers such as Citi and Standard Chartered, leading to a major concentration of risk. As the NPLs surged, most banks more or less stopped lending in the consumer market, with the proportion of system-wide consumer loans falling from 14% in June 2007 to 8% by the first quarter of 2010. Bank chiefs such as Mr Raza expect this to remain a low- to no-growth sector during the coming 18 months, while Moody's anticipates a further decline.

For banks such as Citi Pakistan, whose retail portfolio blew up particularly badly after a rapid period of expansion between 2005 and 2007, the past 18 months have been little more than an exercise in damage limitation. Appointed to his role in 2008 effectively to clean up the mess, Mr Usmani has spent the past two years slowly restructuring Citi's retail business, much of which has already been sold off, including its mortgage, personal loans and auto-loans books. In July, there was further speculation that the bank was in discussions regarding the sale of parts of its remaining credit card portfolio to Habib Bank.

"We pioneered consumer banking in Pakistan, and Pakistan is a viable consumer banking country," says Mr Usmani. "But Citi Pakistan grew the business too rapidly during the 2005-07 years and the timing could not have been worse. We didn't have a big enough business to pump in more and grow ourselves out of trouble, so we got out."

Foreign bankers such as Mr Kazmi believe the international banks "paid the price" of bringing new consumer products to the highly immature consumer market. "They got in there before the infrastructure was in place. When you do consumer lending, you take a clear and calculated risk, and you also have to recognise that there will be other institutions that will piggy-back your efforts by going to your customers and offering them twice the limit," he says.

Standard Chartered, which had its own problems on the consumer boat, is not retreating altogether, though. The bank plans to return to branch-based marketing and focus on its affluent high-end customer pool. "We have no intention to go downstream," says Mr Kazmi, while Citi is not winding down entirely, either. "We intend to continue with the consumer business, but on a different basis, by up-scaling in the big cities," says Mr Usmani.

Badar Kazmi, CEO of Standard Chartered Bank Pakistan

SME potential

If the consumer sector has been hit hard, it was the small and medium-sized enterprise (SME) sector that proved most vulnerable to shocks in the operating environment - in particular the energy crisis, against which small businesses enjoy little or no insulation - posting a rapid increase in NPL ratios from 9.7% in June 2007 to a worrying 22.4% by the end of June 2009. Most institutions have significantly reduced their exposure to this sector during the past three years, with SME loans falling from 15.4% of system-wide loans in June 2007 to 10% by the end of 2009.

Again, Citi was caught in the maelstrom and has had to step back from the SME sector. "We did not feel that we had the wherewithal to ride out the downturn and we didn't have the capital in Pakistan to take a significant hit. We took the decision to scale back. We have worked with customers to find alternative banking arrangements," says Mr Usmani.

Regardless of recent traumas, however, many bankers believe the SME sector will prove highly profitable in the long term and several banks are looking to expand their operations in this area. "In Pakistan a significant opportunity lies in the SME segment," says Mr Kazmi. "Over the past few years we have been building and consolidating and developing our value proposition in this market. We will initially focus at the high end and then go downstream as the economy improves."

NPB is also closely eyeing the SME sector, which Mr Raza believes is being badly neglected. "There is huge demand in the SME sector but banks have not been able to create appropriate products, and the demand is not being met," he says. As the country's largest bank with an extensive network, NBP will have a "natural advantage" in this market, Mr Raza believes, especially in the agricultural sector, into which the bank also hopes to expand.

Islamic finance, meanwhile, is one of a handful of Pakistani sectors presently enjoying growth, thanks in part to the SBP's vigorous promotion of it in recent years. As a result, Islamic finance has surged by about 60% annually since 2005 and now accounts for 5.5% of deposits and 5.3% of assets as of September 2009, according to the SBP.

Many conventional bank chiefs note the growing popularity of Islamic finance products and this has become a major target market for institutions such as Bank Alfalah and Standard Chartered. "We see Islamic finance as a significant opportunity," says Mr Kazmi. "Given the option, a customer who is looking at an Islamic proposition with the same pricing [as a non-Islamic one], will opt for the Islamic product."

Standard Chartered has experienced growing demand for Islamic finance in its wholesale business, but Mr Kazmi also plans to expand its retail Islamic finance operations, with credit cards, deposits and lending products, which will be delivered through a number of new in-branch Islamic banking counters. Bank Alfalah is also expanding its Islamic finance network, which has grown from two branches to 60 during the past seven years, says Mr Aziz.

Sirajuddin Aziz, CEO of Bank Alfalah

Creeping consolidation

Earlier in the decade, the tremendous rate at which Pakistan's banks were growing attracted a surge in foreign investment to the sector. Although the global financial crisis put an end to this trend, most bankers predict further consolidation of the banking sector, particularly since 12 local banks have not been able to meet the government's increase paid-up capital move to Rs6bn ($70m), which came into effect in December 2009.

"Small banks are going to find it difficult to survive in this environment," says Mr Raza. "They will need a minimum balance sheet size and branch network, and banks that don't have that and can't provide the capital won't survive."

For large banks such as NBP with a major network, straightforward commercial bank acquisitions make little strategic sense from a scale point of view, says Mr Raza, but for smaller players such as Khadim Ali Shah Bukhari (KASB), there is more to gain. According to Muneer Kamal, CEO of KASB, the bank is currently eyeing a merger. "We need to increase in size, so if there is a good acquisition or merger, we are open-minded. If I can go from 100 to 200 branches in one acquisition and make good returns, then I would do it." Following extensive losses, KASB is in the process of recapitalising and restructuring, and is presently waiting for the regulator to approve a $40m investment by China's Asia International Finance.

For the time being, however, Pakistan's banking sector is effectively treading water, as many institutions continue to consolidate their existing portfolios, restructure existing loans and wait for a decline in interest rates to stimulate private sector borrowing. "Rates should come down and we'll see the private sector come back in - we may also see the arrival of the consumer market," says Bank Alfalah's Mr Aziz. He adds: "But that may be a little optimistic."