October 29, 2007	Monday	Shawwal 16, 1428

After 9/11, banks overflowed with liquidity and started to discourage deposits by reducing rate of return, fixing minimum deposit limit and imposing various fines if the balance dropped below certain level. Resultantly, the lending rates declined.

Banks then began the search of new avenues to invest their surplus funds and switched over from their past practice of attaching priority to deposit collection to lending.

Agriculture, small business, manufacturing and consumer financing were the potential sectors which attracted the bankers .As the banks had the base and infrastructure mostly in the urban areas, they were mostly engaged in financing commercial/short-term business activities.

They found it convenient to launch various consumer products. Their target was the middle class most of whom belonged to the fixed income/salaried group. Many products were offered to them on easy terms.

This attracted a large section of the population earlier denied loan because formalities could not be meet easily.

The middle income group suffered because of weak economic and social position. They now became eligible borrowers.

This brought the change in the life style of many people who became owners of motor cars and homes overnight.

Apparently this looked as the people had become more prosperous as the policy makers also claimed. But apparent prosperity was not due to the increase in their incomes. It was explained by bank loans.

In fact their disposable income had declined due to the repayment of the loan installments.

Some policy makers explained this phenomenon as a harbinger of prosperity for the society as a whole. Their logic was based on simple classical economics rule that an increase in consumption would increase the demand, prices, profit, supply and then ultimately employment and income of the people.

They may have based their illusion on the American experience where in the 1990s the easy monetary policy and the low interest rates had improved the overall economic conditions including employment and income etc.

But this was not the case here. Instead of development of the whole economy and general well being of the people, some partial and distorted development occurred.

The demand for the new cars was either met by import or the utilisation of the excess capacity. In the housing sector, speculation raised prices of real estate and a house became out of reach of the common man.

Many feared that this glut of liquidity was a temporary phenomenon which on the one hand would give rise to inflation and on the other to the speculative activities.

Moreover, as soon as the situation reverses , difficulties would follow for all borrowers, banks in particular and the country as a whole. That is what has happened. International and domestic prices showed upward trends as the supply did not match the newly created demand.

The US Fed started to raise the discount rates in view of the inflationary conditions in USA. Like many other countries Pakistan is also a part of global currency regime and its monetary policy is dependent on US Federal Reserve and to a greater or lesser degree tied to the dollar.

Thus keeping in view both the domestic price pressures as well as the increase in the US discount rate, the central bank reversed its stance of easy monetary policy.

The interest rates climbed up and immediately showed its effects on the performance of the banking sector. Due to this policy, prices of real estate froze at a point or even declined in some cases.

Similarly, the demand for vehicles and other consumer products also declined.

Financial markets in Pakistan are not developed and as sensitive to the changes in the various sectors as markets of the developed countries are.

Here the banks do not hedge or sell their loans to the pension or various other funds in the secondary markets. The effect of one sector does not transmit itself automatically to the other sectors and the economy as a whole.

One can see how the crisis in sub-prime mortgages in the housing sector has affected the whole US economy. Thus, in the case of Pakistan such a situation affect the banks mainly.

The situation may be evident from the fact that the consumer financing has declined recently.

After registering an extraordinary increase of 70.5 per cent in July-March FY05, the growth in consumer loans has been decelerating, dropping to 30.6 per cent in July-Mar FY06 and further to 11.9 per cent in July-Mar 07.

The deceleration in auto loans, in particular, has the largest share of 8.7 percentage points in the total 19.7percentage points. The slow down in July-Mar 07 was mainly due to the increase in interest rates and more restrained lending by banks.

Banks also became more cautious as in the Jan-Mar 07 quarter, the non-performing loans (NPLs) of the banking system increased by Rs8.7 billion to Rs184 billion.

Agriculture and the consumer sectors were the main contributors. Consumer finance portfolio contributed around one-third of the total addition in NPLs. Thus the infection ratio of this sector increased from 2.2 to 3.2per cent.in 2006. This deterioration was more visible in unsecured consumer products i.e. personal loans and credit cards.

Impounding of vehicles and hiring of toughs for recovery purposes by banks have now become a common knowledge. This situation was bound to happen.

Because as earlier stated the income of the borrowers remained stagnant and it was difficult for them to make the payment of increased mark-up and also meet the other requirements.

This situation induced the State Bank to revisd the prudential rules. Earlier banks were only required to set the credit limit to a certain borrower depending upon the aggregate take-home income.

From, 2006 onwards, banks are required to set these limits after netting the aggregate take-home income by total financing already availed from other commercial banks.

Consumer financing is a relatively new and does not constitute a major part of banks portfolio. Its present ratio in the total outstanding loans of the banks is about 14 per cent.

It is fortunate for banks that the situation of low interest rates, excess liquidity and thus competition of banks for more and more lending against weak or no collaterals did not continue for a long time.

Otherwise, they may have a hard time if a major part of their loans consisted of personal/consumer loans.

Recent sub-prime mortgage crisis has put many banks of US and Europe in crisis and forced some of them to close their business.

Comparatively, Pakistan’s banking system is not as developed and cannot absorb and sustain some major shocks It is imperative that the banks and policy makers show prudence while taking decisions.