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Asia-PacificAugust 1 2011

Profit performance masks the challenges faced by Pakistan's banks

Although Pakistan tops The Banker’s Top 1000 World Banks profit rankings, the country’s banking sector faces a number of difficulties as it copes with a challenging economic environment.
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Profit performance masks the challenges faced by Pakistan's banksState Bank of Pakistan

One of the more notable features of The Banker's 2011 Top 1000 World Banks ranking was the appearance of Pakistan at the top of the country profits on average capital list, with 36.41%, ahead of second-placed Brazil with 31.95%.

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Behind these impressive-looking figures, however, is a story of Pakistan’s high inflation and interest rates, which partly accounts for the profits of National Bank of Pakistan, Habib Bank, MCB Bank, United Bank and Allied Bank. Otherwise known as Pakistan's ‘big five’, these are the country's only entrants in The Banker's Top 1000 ranking. Meanwhile, the rest of Pakistan’s smaller banks struggle to be profitable in the face of higher capital requirements, and the vast majority of the country's population remains unbanked.

Policy problems

Pakistan is contending with a high inflation rate of 13.9% and the State Bank of Pakistan (SBP) – the central bank – has maintained a policy rate of 14%. The SBP's monetary policy has been a contentious issue and in mid-July 2011 Shahid Kardar, the bank's governor, offered his resignation over policy differences with the government, quitting a role that had already seen a high turnover in recent years.

In this high-inflation, high-interest environment, the big five banks have been able to have net interest margins that are unusually high compared with other markets. “They have the ability to charge sizeable spreads; that is why they rank higher than other countries,” says Aahyan Mumtaz, financial analyst at the Pakistan Credit Rating Agency (Pacra).

The larger banks have the advantage of lower funding costs when compared with the country’s smaller banks, which is aided in part by their economies of scale and branch network, which gives them access to a cheaper deposit base. While the cost of funds may be low, the high rates of interest have been a cause of concern for some. Rating agency Moody’s notes that these high interest rates are likely to put pressure on borrowers’ ability to repay their debts, especially in light of Pakistan’s weak economy.

Consumer lending cutback

Sirajuddin Aziz, CEO of Bank Alfalah, says that banks in Pakistan have typically shied away from lending to consumers because once defaults kicked in, legal complexities made it difficult for banks to chase their bad debt. These difficulties have meant that banks have now steered clear of this kind of lending to individuals.

Perhaps of greater concern, however, is the level of lending to the government. Mr Mumtaz at Pacra says that there was a lot of contraction in the banking sector from 2008, following the political turmoil in Pakistan and the global recession. He says that the banks moved to less risky lending, and so avoided lending to the private sector and invested in government securities.

This echoes the words of Nadeem Hussain, president and CEO of Tameer Microfinance Bank, who says that the private sector and consumers have been squeezed as the major banks have focused their efforts on lending to the government.

Such a strategy threatens to further damage the long-term prospects for Pakistan's economy, as the knock-on effects of cutting back on lending to the private sector and individuals takes hold. Mr Aziz at Bank Alfalah says that the challenges of the banking sector are intertwined with the macroeconomics of Pakistan. But he adds that the two can improve in tandem if, for example, the banks finance car loans, they are also helping the country’s industry at the same time.

Government reliance

However, the outlook for both the country’s economy and banking sector is not so encouraging. Moody’s gave a negative outlook for Pakistan’s banking system in December 2010 and raised concerns with the high level of the big five banks’ exposure to the government and public sector.

Moody’s estimates that at the end of September 2010 these government-related exposures amounted to 36% of the big five banks’ total assets. Between July 2010 and April 2011, the government borrowed Rs196.3bn ($2.28bn) from the SBP, and borrowed Rs275.9bn from the major banks during the same period, according to figures from the central bank.

Top 5 Pakistan Banks

These high levels of lending to the government have enabled the big five to benefit from the high interest rate environment and lend to a less risky borrower – the government – than if they were lending to the private sector or individuals. And because of their size, they are less affected by the minimum capital requirements that are being imposed on Pakistan’s banking industry.

The higher capital requirements are part of the central bank’s efforts to improve stability in the sector and streamline the number of players. Anwar Zaidi, CEO of Habib Bank UK, says that the regulatory regime in Pakistan has been robust and there has been a lot of emphasis by the regulator not just on the banks’ stability but also in overseeing the quality of people that are running the organisations.

Banks such as Habib Bank, which ranks second in Pakistan in terms of Tier 1 capital, can easily meet the new requirements, but executives of smaller banks complain they are struggling to meet the minimum requirements to run a bank in Pakistan.

Mr Hussain of Tameer Microfinance Bank says: “The central bank increased the minimum capital requirement so the small banks have no choice but to amalgamate, consolidate or get sold out.”

Get big or get out

This is a major concern for small banks such as JS Bank. Kalim ur Rahman, the bank’s president and CEO, says that Pakistan's small banks face difficulty in meeting the capital requirements and struggle to make enough profits. He adds, however, that JS Bank is comfortable in meeting the targets of Basel II capital adequacy ratios, but the central bank's minimum capital requirements are more difficult.

The minimum amount, as stipulated by the central bank, has been gradually increasing. The minimum capital requirement for the central bank’s deadline at the end of December 2010 was Rs10bn. At the end of 2011, the minimum requirement will increase to Rs15bn, putting further pressure on the smaller banks, many of whom have been unable to meet the levels of the earlier deadlines.

These are just some of the challenges that Pakistan's banking industry faces, which are all being played out against a backdrop of political instability, frequent power shortages, and the aftermath of the devastating floods of 2010.

Political risk

Not only do the domestic security challenges drain the resources of the government, in fighting terrorism and extremism for example, but it also makes the country less attractive to foreign investment and weakens the appetite for borrowing.

Mr Mumtaz at Pacra says that the main hindrance to economic recovery is political risk. “The political situation is not ideal for investment. There is a dearth of foreign investment and the pace of recovery is going to be slower than anticipated,” he says, adding that it could take three or four years for the economy to recover.

The domestic security situation also affects Pakistan’s sovereign credit ratings, with Standard & Poor’s highlighting concerns with the country’s regional insurgencies, sectarian strife and volatile domestic politics. Its research says: “Almost four years after the transition from military rule to democracy, a high degree of political instability still persists in Pakistan, with a pervasive negative effect on policy-making, legislative efficiency and, ultimately, economic performance. The instability revolves around the traditional rivalry and adversarial relationship between the ruling Pakistan People’s Party and the main opposition Pakistan Muslim League Nawaz Sharif Faction.”

Added to the challenges of operating in Pakistan, the country was adversely affected by serious flooding in the summer of 2010. The central bank estimates that the floods inflicted $10bn-worth of damage to the economy and knocked two percentage points from the country’s economic growth.

In terms of the direct impact of the floods on the banking sector, however, the effects were minimal. Moody’s states that the banking industry was not directly affected by the floods as many of the areas that were submerged were rural and in regions where the population is unbanked.

Mr Zaidi at Habib Bank UK says that while the floods were devastating, there has been a silver lining to the natural disaster. He says that the floods actually nourished the soil and so the agriculture sector has had a good cotton and wheat crop this year.

Positive developments

While there are continuing challenges for the banking industry in Pakistan, such as social unrest and frequent power shortages, there are some positive developments and Mr Zaidi points to the advancements that have been made in recent months.

Where in the past there may have been a perception that the large banks were inefficient and that customers would rather take their business elsewhere, things are now beginning to change. Mr Zaidi says that the larger banks have improved their customer service, focused on the quality of their staff and attracting the right calibre of people with attractive pay packages, and they have improved the appearance of their branches.

Improvements have also been made in the provision of online banking and the use of mobile phone technology has developed in Pakistan. For the large banks, a mobile phone banking application enables customers to receive SMS alerts about the transactions related to their accounts.

Mobile payments

For the unbanked population in Pakistan, however, mobile phone technology has a much greater role to play. Branchless banking projects in Pakistan have begun to pick up and address the low penetration of banking in Pakistan. By reaching out to the unbanked population, such initiatives also aim to alleviate poverty through microfinance initiatives.

This is the objective of Tameer Microfinance Bank, which in 2008 entered into a partnership with mobile operator Telenor Pakistan which bought a 51% stake in the bank. This enabled the launch of the Easypaisa mobile payment service in 2009, which allows customers to pay bills and send remittances without needing to have a bank account.

Mr Hussain, the bank’s president and CEO, explains that Easypaisa currently handles 3 million transactions a month. When looking at the banking industry in general in Pakistan, Mr Hussain says that Tameer Microfinance Bank is not looking to compete with other banks at all; it is only focused on capturing the unbanked population of Pakistan.

The banking landscape in Pakistan is currently one where the major five banks dominate the market and the smaller banks are fighting over the remaining share of the market. Despite this, bank penetration remains low. Mr Hussain estimates that only 12% of Pakistan’s population has access to banking services. His mission is to focus on the remaining 88%. Unlike many other microfinance initiatives, Tameer Microfinance Bank is a private-sector bank that aims to be commercially sustainable and not reliant on the help of non-governmental organisations.

Branchless banking

Another branchless banking initiative is one delivered by United Bank, which has launched a similar mobile payments proposition named Omni, where the customer’s mobile phone number functions the same way a bank account number would in traditional branch banking.

According to figures from the country’s central bank, microfinance has achieved improvements in outreach, financial and operational performance. Overall the microfinance sector is currently serving more than 2.1 million active borrowers with a gross loan portfolio of Rs25.5bn as of the end of 2010. Mr Hussain believes that the level needs to reach 10 million or 12 million customers to be able to make a difference in terms of poverty alleviation.

With so many of Pakistan’s population yet to have access to financial services, the potential is immense although many challenges remain. For the rest of the banking sector, however, the challenges are slightly different. For the smaller banks, the challenges are in meeting minimum capital requirements and dealing with consolidation. And while the large banks may continue to reap large profits from high interest rates, the economic environment in which they operate will be challenging over the coming months.

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