January 08, 2007	Monday	Zilhaj 17, 1427

THE banking sector represents an intriguing anomaly. Despite considerable improvement in the asset quality of the banking sector, the difference between bank lending and deposit rates is widening. At least, it does not show any signs of narrowing. One would expect that as non-performing loans fall, operational inefficiencies are removed, competition between banks increases, and tax structure becomes favourable, the spread should be falling. Well, the opposite seems to be happening in Pakistan.

What is the cause of this phenomenon? This question becomes even more important when we consider the fact that, in Pakistan, bulk of investment is financed through banks and other avenues of financing such as IPO and corporate bonds are not really tapped into.

If one critically examines the factors that are commonly cited as explanations for the widening spread, it becomes fairly apparent that these explanations lack merit. Banks are primarily intermediaries providing an intermediation service. They match savers and borrowers and in this process of matching savers and borrowers, they incur costs and take risks for which they are rewarded in the form of the spread.

Clearly, with the banking sector reforms, the operating efficiency of banks has improved, meaning that high spread cannot be attributed to such costs. What about risk? It has been argued, as the State Bank of Pakistan has pointed out, that the maturity profile of deposits and advances has changed adversely. That is, banks’ deposits have shifted towards shorter maturity and their advances have shifted towards longer maturity. This asset/liability mismatch has made banking more risky. More risk requires more reward, hence the high spread. However, in the case of Pakistan, this explanation is hard to swallow.

Banks are not really worried about maturing deposits; they are worried about maturing deposits that do not get rolled over. Deposits that do not get rolled over are a very small fraction of maturing deposits so unless the mismatch is huge, which it isn’t, the high spread cannot be explained.

Another argument is that banks are now increasingly featuring riskier clients such as Small and Medium Enterprises in their portfolio; hence they are demanding high spread. This brings us to a peculiar feature of the banking sector.Private banks are in active collusion with firms for the purpose of tax-evasion. A simple example will clarify the issue. Suppose you are an owner of a firm, let’s say a medium sized textile unit. You have made a profit of Rs50 million but you do not want to declare it since you want to avoid paying taxes on it. You need to re-invest that money into your business to further expand it. How would you do it without declaring your profit? You go to a bank, you give Rs50 million cash to the bank, the bank will return the money to you and will show a loan of Rs50 million issued to you with your inventory of cotton etc. as collateral in the books maintained for SBP.

In the “real” books (not to be shown to SBP), the bank’s loan is 100 per cent secured (since it is backed by cash) and you have managed to re-invest Rs50 million in your business without declaring the profit and consequently without paying taxes on the profit you have made. Basically, through this exercise, you have managed to convert your equity (retained earnings) into debt for tax advantages. Why do the banks do it? Firstly, their loans are 100 per cent secured, hence no default risk. Secondly, they get to charge lending rates that are on the higher side since the tax advantage accruing to the firm is substantial. It is a win-win for both parties with the national exchequer as the main loser.

This brings us to the main point of this article. The high banking spreads are not because of high risks at all. They are due to the tax-evasion services that banks are providing to the private sector. Since privately owned firms are likely to actively engage in tax evasion, the spread will rise as the share of medium sized enterprises increases in the portfolio of banks. Hence, the high observed spread is an indication of the extent of tax-evasion going on in the economy with the help of private banks.

The collusion between a bank and a firm for tax-evasion as described earlier requires a high degree of trust. No wonder, bank lending in Pakistan is highly segmented with certain banks primarily providing services to their own communities.

To sum up, the explanation of the high banking sector spread may lie in the bank-firm collusion for tax-evasion, rather than on risks associated with changing maturity profile or loan portfolio.