Problems at Pakistan’s banks, including fines and falling profits, have seen foreign investors head for the exit. Could interest from China and a growing Islamic finance sector improve their prospects? Edward Russell-Walling reports.


The State Bank of Pakistan (SBP), the country’s central bank, gave the financial sector a New Year’s treat in January when it raised rates for the first time in four years. The banks needed cheering up – their profits fell almost across the board in 2017. While earnings may improve in 2018, various foreign owners of local institutions have had enough and want to sell their stakes.

Pakistan’s banks have been under the cosh in other ways. In 2017, New York regulators fined the local branch of Habib Bank (HBL) $225m for “serious and persistent” failures to comply with anti-money laundering (AML) rules. They cited instances of wire-stripping – where information is deliberately removed from a payment – and said the bank had failed to respond satisfactorily to earlier warnings.

HBL agreed to surrender its New York branch licence, and group CEO Nauman Dar announced not long afterwards that he would step down at the end of 2017. Moody’s promptly downgraded the bank’s baseline credit and counterparty risk assessments.

On alert

The incident put the whole Pakistani banking sector on alert, but worse was to come. At the end of February 2018, after Pakistan did too little too late and then bungled its diplomacy, the Financial Action Task Force (FATF) said the country would be placed on its grey list in late June after The Banker goes to press. It was given three months to draw up an action plan.

The grey list catalogues countries that FATF believes are not doing enough to combat money laundering and terrorist financing. Pakistan has been on the list before, from 2012 until 2015, when it finally passed acceptable AML and countering financing of terrorism legislation.

HBL’s New York transgressions will not have helped Pakistan’s cause. FATF was also miffed that the last government unilaterally introduced a foreign asset amnesty scheme in its final budget without consulting it. But the main driver was a hostile US, determined to pressurise Pakistan into acting against certain UN-designated terrorist organisations.

The Financial Action Task Force means a transformative journey for the entire Pakistani banking industry

Muhammad Aurangzeb

A grey list status would be unhelpful, to say the least, for Pakistan’s international financial dealings. Additional checks on transactions, particularly remittances, would add to delays and compliance costs. Other financial institutions would be more wary of Pakistani counterparties, and local fund managers would find it harder to attract international investments. The sovereign credit rating could also be at risk, with fallout for all international borrowing.

Local banks are all too well aware of this, and compliance now accounts for the most growth in new jobs and salary increases in the country, according to one Lahore-based banker. 

Pakistan joins the likes of Iraq, Syria and Yemen in FATF’s sin bin. The listing seems more about Pakistan coming to heel on terrorist and security issues than about bank processes. But if FATF decides it is not co-operating in the desired way, it could be moved to the black list, currently occupied only by Iran and North Korea.

Raising the bar

“FATF means a transformative journey for the entire Pakistani banking industry,” says new HBL CEO Muhammad Aurangzeb, who was previously CEO of the global corporate bank, Asia-Pacific, at JPMorgan. “The bar has been raised – all global banks have had to go through it. But the cost of doing business will go up,” he adds.

Mr Aurangzeb does not believe that Pakistan will be demoted to the black list. “If you look at the names on the black list, any country would have to work very hard to get onto it,” he says.

For Mr Aurangzeb and for HBL, the New York affair was something that happened in 2017. Now, he says, the focus is on domestic growth (90% of HBL’s business is domestic), as well as getting the international division back on a growth track. Given that the New York branch made less than $20m over 10 years, the fine made a much bigger hole than closing the business will. “We need to be very clear about our value proposition in every location,” says Mr Aurangzeb.

HBL is Pakistan’s biggest bank by Tier 1 capital, by assets and by deposits. In 2017, thanks largely to the fine, the bank also recorded the biggest fall in pre-tax profits, of 51.6%, to $261m. Its return on capital fell accordingly, from 38.9% to 20.7%.

Tightening spreads

But HBL was only an extreme example of shrinking profits elsewhere in Pakistan. As interest rates have come down, banking spreads have tightened every year for the past five. In March 2018 they averaged 472 basis points (bps), compared with 603bps in December 2014. 

As banks booked gains from higher yielding Pakistan investment bonds and reinvested proceeds into shorter dated T-bills, this has boosted 2016 performance and squeezed 2017 income. As a result, only a handful of the country's 30 commercial banks were able to post increased profits in 2017, with none in the top five.

The Chinese can’t afford to have the whole Belt and Road Initiative funded by its own banks

Shazad Dada

Pre-tax return on assets across all banks has declined from 2.5% in 2015 to 1.6% in 2017, and return on equity from 25.8%% to 19.5%. Risk-weighted capital adequacy ratios have fallen from 17.3% to 15.8%.

Balance sheets continue to grow, however, with total assets growing 15.9% to Rs18,342bn ($151.6bn) in the year to the end of 2017. Advances are growing faster than investments, continuing to reverse an earlier trend, though investment growth has picked up again since 2017. Deposits grew by 10.3% to Rs13,012bn.

Moody’s has given the industry more or less a clean bill of health. Its most recent outlook, published in February, is 'stable'. The rating agency assumes banks will be supported by an accelerating economy, in which gross domestic product will again increase in 2019, though some would disagree with that. 

It expects lending to the private sector to grow between 12% and 15% in 2018 as the country's economy improves, despite a widening fiscal deficit, which the banks will continue partly to finance. 

Official statistics show private sector credit growing at 5.7% in the first half of fiscal year 2018, compared with 8.1% in the previous corresponding period. This reflects maturing projects in the power, construction and cement sectors, which reduced demand for additional borrowings. The central bank has noted, however, that private credit had “recovered strongly since mid-January 2018”.

NPL boost 

Moody’s also expects Pakistan's problem loans to continue to decline in the current “supportive” macro environment. The industry’s non-performing loan (NPL) ratios have been falling steadily, and stood at 8.3% of gross loans in March 2018, compared with 9.9% a year earlier. 

The agency points out that asset risk remains high, thanks to weaknesses in the legal framework, inefficient foreclosure processes and a scarcity of information for assessing borrower creditworthiness. High exposure to government bonds links banks’ creditworthiness with that of the sovereign and, given the latter’s low B3 rating, is their biggest challenge.

On the plus side, Moody’s points to stable customer deposits, making up some 70% of total assets and expected to grow at 12% to 15% this year. Cash and bank placements account for about 11% of assets, with another 44% in repo-able government securities, providing sound liquidity. 

Capital buffers remain modest. Tier 1 ratios have declined over time, from 14.4% at the end of 2014 to 12.9% in March 2018. Moody’s believes they will recover once higher regulatory requirements become effective throughout 2018 and 2019, and capital will be boosted by higher profit retention, capital increases and optimisation measures.

The number of commercial banks has remained steady at 30, though this includes one newcomer and one disappearance by acquisition. The newcomer is Bank of China, which began operating out of its Karachi head office in late 2017. “We plan to have branches in all the key economic centres, including Lahore, Islamabad, Faisalabad and, most essentially, [the new southern port of] Gwadar,” says Li Tao, country head and CEO of Bank of China’s Pakistan operations.

Chinese inroads

Bank of China joined its compatriot, the Industrial and Commercial Bank of China, which has been in Pakistan since 2013. The draw for both is the China-Pakistan Economic Corridor (CPEC), whose initial power and infrastructure projects are being funded mostly by Chinese institutions. 

Bank of China’s total commitments under CPEC now exceed $500m, and it expects to increase that multiple times in coming years. It offers investment banking, trade finance and cash management products to Pakistani (not necessarily CPEC-related) and international clients, and will soon include bond underwriting, equity financing and custody.

It has also been granted SBP approval to establish local yuan (onshore renminbi) clearing and settlement in Pakistan. “We provide liquidity and act as market maker for yuan in Pakistan,” says Mr Li. This year, the SBP agreed that trade and financial transactions between Pakistan and China could be denominated in yuan. An earlier Chinese proposal to allow yuan as legal tender in Gwadar had been rejected.

Mr Li makes the point that CPEC is not just for China, providing opportunities for other international players. Right now, for Pakistani banks, CPEC has only a trickle-down effect, with lending to local cement and logistics companies piggy-backing on Chinese-funded projects. “As the Chinese bring in industry and expertise, and want to set up joint ventures with Pakistani firms, we will be more involved,” says Farhan ullah Khan, chief financial officer of Allied Bank, which is ranked the fifth largest in Pakistan by Tier 1 capital. 

Shazad Dada, CEO of Standard Chartered Bank (Pakistan), agrees. “The next phases of CPEC will bring in others,” he says. “The Chinese can't afford to have the whole Belt and Road Initiative funded by its own banks.” The internationalisation of the renminbi is a big opportunity for Standard Chartered, Mr Dada believes, given its 150-year history in China, with clients on both sides of the border.

Pakistan's disappearing institution is loss-making NIB Bank. Temasek, Singapore’s sovereign wealth fund, sold its majority stake in NIB for less than book value to MCB, the second largest bank in Pakistan by Tier 1 capital and the fourth largest by assets. MCB paid with its own shares. It was drawn by NIB’s tax losses and NPLs (which it has a strong record at recovering). It also converted 90 of NIB’s branches into Islamic banking outlets for its wholly owned but operationally separate Islamic bank subsidiary.

Islamic growth

Islamic banking in Pakistani continues to grow faster than conventional banking. In the year to December 2017, total Islamic banking assets in the country grew by 22.6% to Rs2272bn, compared with just under 16% for the industry at large. Deposits grew by 19.8% to Rs1885bn (industry 10.3%). The number of Islamic banking branches grew 11% to 2581, and the Islamic share of the overall industry was 12.4% of assets and 14.5% of deposits.

Meezan Bank remains the biggest and most successful Islamic institution, ranking eighth by assets and seventh by deposits among all Pakistani banks. “We address the short- and long-term financial needs of our customers with Islamic products,” says Ariful Islam, Meezan deputy CEO. “The challenge is in deploying liquidity and in the availability of Islamic government paper.”

While the government has promised to help Islamic banks by issuing more sukuk, these require unencumbered government assets, which are in short supply.

Meezan broke new ground in May when it began marketing a Rs5bn (plus Rs2bn greenshoe) additional Tier 1 perpetual sukuk, Pakistan's first. In 2016 the bank had raised a similar Rs7bn through private placement of a 10-year Tier 2 sukuk.  

For all its success, Meezan is one of three Pakistani banks where foreign shareholders want to sell out. Though each has its individual reasons, they share a general sentiment that lavish Pakistani banking returns are a thing of the past. Kuwait’s Noor Financial Investment owns 49.1% of Meezan. It now has SBP approval to sell 9.59%, but only to international portfolio investors. With the current pressure on foreign reserves, permission for foreign owners to sell large stakes to local buyers is unlikely to be forthcoming.

Other would-be sellers are the Abu Dhabi Group, with a majority stake in Bank Alfalah, Pakistan’s sixth largest bank by Tier 1 capital, and Faysal Bank, which is majority owned by Bahrain’s Ithmaar Bank. 

Rising rates

The policy rate was hiked again in May, by 50bps to 6.5%, and bankers expect one or even two further rises b the close of 2018. In a rising rate environment, the attractions of government paper will doubtless reassert themselves. Commercial banks have often been accused of not lending enough to the real economy, or supporting riskier sectors such as small and medium-sized enterprises (SMEs). The SBP, which has never been an enthusiastic proponent of directed lending, is now taking a firmer line.

It has proposed a five-year tax holiday for income from low-cost housing mortgages. And it has introduced bank targets and incentives for lending to SMEs, with the express aim of returning their share of the private sector from the present level of under 9% to 17%, where it was in 2008. 

Some see a particular role here for Islamic banking. “Corporate margins are shrinking and liquidity is available,” says Ahmed Shuja Kidwai, CEO of Al Baraka Bank, one of Pakistan's five standalone independent Islamic banks. “Banks are flush with money and they need to use it. I believe Islamic banking will flourish in the SME and microfinance sectors.”


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