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Asia-PacificJuly 3 2017

Pakistan banks branch out to fight drop in profits

While relatively healthy, Pakistan’s banks are looking for ways to diversify in a bid to boost profits. These include digital branches, non-branch banking and more innovative lending, reports Edward Russell-Walling.
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Habib Metro

Pakistan’s banking industry remains healthy, growing its assets and deposits and showing improvements in asset quality and capital adequacy. Lower interest rates and investment returns have hurt profits, however, and are prompting a drive to diversify lending.

The basic statistics reveal a sector that is in generally good shape. Assets in 2016 increased year on year by 11.9% to $151bn, according to the central bank, the State Bank of Pakistan (SBP).

An investment environment

Investments, mainly in government securities, were the largest component in asset growth, increasing by 9.1% to $71.6bn. But advances, which had been stagnant before picking up from 2013 onwards, grew by a more vigorous 14.2% to $52.5bn. That vigour has continued into 2017, with advances in the first quarter up by 17.2% year on year, compared with a 7.8% growth in investments.

Deposits, on the other hand, grew by 13.6%, compared with growth of 12.6% in 2015. Deposit flows fell after the imposition in 2015 of a withholding tax on non-cash banking transactions – an attempt to increase tax revenues from the ‘informal’ economy. However, the SBP is keen to point out that deposits are back on a growth trajectory, increasing by 14.4% year on year in the first quarter of 2017.

Asset quality also continues to improve. The industry’s gross non-performing loan (NPL) ratio fell from 12.3% in 2014 to 10.1% at the end of 2016, declining further in the first quarter of 2017 to 9.9%. The SBP says the possible “legacy quantum” of NPLs has hovered around the Rs600bn ($5.72bn) mark during this period, and the infection ratio improvement has been driven primarily by an increase in loans. “However, it is encouraging that the incidence of new NPLs is being contained,” it adds.

The average capital adequacy ratio was 16.2% at the end of 2016, against 14.9% in 2013. It eased off to 15.9% in the first quarter 2017, thanks to the growth in risk-weighted advances, but that compares favourably with the domestic regulatory minimum of 10.65%.

Declining profitability

The only banking indicator that has declined in Pakistan is profitability, though not by much. After earning $3.14bn before tax in 2015, Pakistan’s banks had to make do with $3bn in 2016, seeing their pre-tax return on assets fall from 2.5% to 2.1%. Pre-tax return on equity declined from 23.8% to 21.8%, and the pressure on profits has continued into the present year, with year-on-year profits down by 7.9% in the first quarter.

The figures bear out what is happening in the wider marketplace. In November 2016, just as banks were hoping that interest rates were going to rise, the SBP cut its policy rate by one-quarter of a percentage point to 5.75%. At the same time, the government has been borrowing less, now that an International Monetary Fund programme has ended, and government paper has been yielding less.

The result is that banks are less able to rely on their old model of mopping up low-cost deposits and lending most of it to the government. They are now pushing into lending markets that were previously neglected, and competing more fiercely with their traditional products.

HabibMetro's commodity move

The experience of Habib Metropolitan Bank (HabibMetro) is fairly typical. Owned by Habib Bank AG Zurich, it has traditionally ploughed a profitable furrow in trade finance, though it used to be Karachi-centric. Now, in order to capture both legs of its trade transactions, the bank has more than 150 branches across Pakistan. Recently, however, it has had to respond to a changing market.

“Trade finance used to be our niche,” says Sirajuddin Aziz, CEO at HabibMetro. “But with returns from government securities tapering, there is growing interest from the big banks and a price war on trade products. This has had an impact on margins for the whole industry.”

As others have entered its market, HabibMetro has ventured into pastures new. As a subsidiary of a Swiss bank, it has been “a bit shy” about going into commodity finance, but it is now doing some wheat and rice financing. “We stayed away for a long time, while other banks had large exposures,” says Mr Aziz of this business. “But this lending is guaranteed by the state and does not require capital backing. Pricing is very fine, but it has the benefits of large ticket borrowing and the guarantee.”

The mother of invention

While the bigger banks are more broadly spread, they also feel the need to be more inventive on the loans front. Sima Kamil is the new CEO of United Bank Limited (UBL), having come from Habib Bank Limited (HBL), where she was head of branch banking. She says part of UBL’s future strategy will be to do more lending.

“In corporate banking, if you are providing working capital for large corporates, the spreads are very thin,” she says. “For a big borrower, there’s a discount to Kibor for short-term lending. So to make up for that, we want to do more project finance.”

Project finance is taking off in Pakistan because of the China-Pakistan Economic Corridor (CPEC), she says, adding: “It’s long-term but the spreads are better.” Project finance for a blue-chip borrower could be priced at Kibor plus 150 basis points. Add in fees for project advice and syndication and ancillary income from items such as letters of credit, and yields can get to 2% to 2.5%.

“But you’ll never get really good yields unless you look at other sections of the economy,” says Ms Kamil. “So consumer finance such as car loans, where we are relatively small, will be key for us. The returns are much better, though it’s traditionally risky and has higher admin costs because of the small ticket nature.”

Until recently, consumer finance was not a high priority and UBL is currently number three in the market. In many other segments it runs second only to HBL, which is also the largest bank by assets, Tier 1 capital and pre-tax profits. Part of Ms Kamil’s strategy will be to close some of those gaps. “We would like to be number one in some areas,” she says. “We can certainly get close in absolute profit; we were the only private sector bank [in Pakistan] that grew its profits in 2016.”

HBL’s development focus

At HBL, there is a more relaxed view, which doubtless comes more easily to a market leader. It is a quoted company with a 40% free float, but is still majority owned by the Aga Khan Fund for Economic Development. That gives it more than a strictly commercial outlook, and CEO Nauman Dar says the bank aims to play a role in the development of the country.

“Pakistan doesn't have a policy bank, but we have assumed that role,” he says. As an example, he points to the 10% equity stake taken by HBL in the first phase of the Thar coalmine and power plant projects. Thar is one of the headline CPEC ventures and will use some of Pakistan’s huge unexploited coal reserves. “It took equity to make it happen, so we did our bit to unlock the project,” says Mr Dar. “Now everyone and his brother wants to put up a power plant.”

For similar reasons, microfinance and financial inclusion are an integral part of HBL’s strategy. In a country where all houses are still equity financed, HBL is looking seriously, along with the central bank and government, at how to create a mortgage segment. “It’s important for economic growth,” says Mr Dar.

The CPEC is having an effect on loan-to-asset ratios too, he adds. “CPEC has a big element of local financing, and if it’s bankable we have appetite,” he says. “Projects are coming along now and we are seeing the effect of this in our portfolio, as we move that money out of government securities.”

Tapping the CPEC

Pakistani industry was slow to mobilise for the CPEC, but it is starting to pay more attention. The result is a growing number of partnerships between Pakistani and Chinese firms. “That makes [Chinese initiative] One Belt, One Road more inclusive, and it’s important that it does,” says Mr Dar. “If business is proactive and plays a role in CPEC, we don’t become a client state but part of the process.”

HBL has become the first Pakistani bank licensed to open a branch in China, which it will locate in Ürümqi, in Xinjiang province. The SBP recently granted a banking licence to Bank of China, having done the same for Industrial and Commercial Bank of China in 2013, but says there are no more Chinese licences in the pipeline.

Like HBL, some other Pakistani banks are embracing the CPEC wholeheartedly. HabibMetro, for example, has decked out five strategically positioned branches with Chinese signage, and is training staff to speak Chinese. “Our Islamabad branch now looks as if it’s in Chinatown,” says Mr Aziz.

He adds that the bank is doing good business with Chinese banks, offering them cash management facilities and use of the HabibMetro network.

MCB Bank, on the other hand, appears to be biding its time. It has a reputation for being risk averse, but is also very profitable. The bank’s capital assets ratio is the highest of the major banks, but so is its return on assets. It has not piled into CPEC ventures in the way HBL has, probably because it regards the outcomes as uncertain. It is certainly not alone in wondering how the economy will service Pakistan’s increased foreign exchange liabilities over the next few years.

Going digital

“In Pakistan, the name of the game is cost of funds,” declares one Karachi banker. This adds to the attractions of financial inclusion, branchless banking and digital banking in general. UBL is widely perceived to have led the field in digital innovation, and claims to be the only commercial bank with a viable branchless offering. “Others have tried and not done well,” says Ms Kamil. “They have had to roll back and retune.”

Branchless banking is not the only way to cut costs, as UBL hopes to show with Pakistan’s first digital branch. Located in Karachi, it has no staff, is accessible at all hours and allows customers to open an account, deposit and withdraw funds, transfer funds to another bank and be issued with a debit card. It does not, however, do loans. If this pilot is successful, the bank intends to roll out these digital branches nationally.

Branchless banking indicators are on the up, nonetheless. Between June 2015 and December 2016, the number of branchless accounts in Pakistan rose by 83% to just under 20 million – about 10% of the population, up from 1% in 2012. At the same time, the number of bricks-and-mortar branches continued to rise from 11,937 in June 2015 to 14,096 at the end of 2016.

Financial inclusion

A new law has created a registry that will allow moveable assets to be posted as collateral, in the hope that this will boost currently low levels of lending to small and medium-sized enterprises (SMEs). After remaining stagnant for some years, SME lending rose nearly 33% from the end of the financial year in June 2016 to December 2016 to $3.8bn. In microfinance, the gross portfolio grew 12.8% over the same period to $1.3bn, with 4.6 million borrowers.

The goal is 10 million borrowers by 2020, according to Zubyr Soomro, chairman of the Pakistan Microfinance Investment Company (PMIC), a wholesaler of funds for microfinance lenders. There are 35 of these, and the nine licensed banks among them account for 70% of the loan portfolio. PMIC is focusing on helping the other 26 non-bank lenders scale up and build capacity, while helping the microfinance banks with capital markets access for long-term funds and with payments infrastructure.

To help lenders gain the experience and confidence to make bigger, longer loans, PMIC has created five specialist categories it calls ‘verticals’. These include solar power; ‘livelihoods’ (loans to would-be plumbers or hairdressers); agriculture loans; and small business loans. “Our most ambitious vertical is housing,” says Mr Soomro.

The answer may lie in piecemeal finance, to match piecemeal construction. The poor tend to build incrementally, first one room and then, over the years, another. “So because they build in small bites, you can structure the finance over smaller periods,” he says. “A three-year loan instead of a 20-year loan, then another three-year loan. Or, because you were a good borrower, a five-year loan this time.”

One important element in financial inclusion is Islamic banking, which appears to be going from strength to strength in Pakistan. “Islamic banking has shown very good growth, and is playing an important role in private sector credit extension,” says SBP acting governor Riaz Riazuddin.

In 2016, total Islamic assets grew 15.1% to $17.bn, or 11.7% of all banking assets and deposits rose by 14.4% to $15bn, representing 13.3% of all deposits. At the end of 2016, there were 21 dedicated Islamic banking institutions and 2322 branches, a 12% increase over the year.

Islamic banking has also done more than its conventional rivals in consumer finance. The ‘diminishing musharaka’ allows Islamic banks to provide much-needed housing finance, while the ijara structure is proving popular for motor vehicles.

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