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Interest rate and the quality of bank assets

January 19, 2009

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AS their western peers continue to endure mounting losses owing to the global financial downturn, banks in Pakistan face somewhat a similar situation. According to the SBP, the nominal value of non-performing loans (NPL) has gone up to Rs288.37 billion, up 14.8 per cent since June 8, from Rs251 billion.

The commercial banks contributed Rs33 billion out of a total increment of Rs37 billion in NPLs during the first quarter of the fiscal 2009. The NPLs of public sector banks swelled up to Rs70.7 billion as the NPL to total loan ratio hovered close to two per cent, well above 1.1 per cent in June 2008.

Analysts believe that economic downturn coupled with monetary tightening are the primary causes for the upsurge in the NPLs. As per IMF conditionality, the SBP had revised its key policy/discount rate up to 15 per cent to contain inflationary pressure. This hike in policy rates led to a subsequent rise in the KIBOR (inter-bank rates) which banks use as a benchmark while offering credit lines to a customer. Now that the 6-month KIBOR is close to 15.6 per cent, borrowers are made to pay up to 20 per cent per annum. It raises the financial costs, making it difficult for industry/trade to thrive.

More than 80 per cent of bank loans are sanctioned on floating interest rates. This is an easy way for lending institutions to safeguard/hedge themselves against any unexpected hike in discount rates. But borrowers who availed credit facilities for a period of 3-5 years at a time when KIBOR was close to 14 per cent, now end up paying mark-up rates 2-3 per cent in excess of what they have been paying in the past.

With the exception of Shariah compliant banks which require prior consent of the customer before they actually increase the “profit” rates, conventional banks have been least hesitant in increasing their customer’s mark up rates without actually notifying their valued customers.

The recent robust growth in the consumer-banking sector seems to have added a lot to this problem. The borrowers were tempted to avail attractive credit card facilities, “uncollateralised” personal loans, and easy car financing facility. A salaried individual could carry dozens of credit cards in his bulging wallet given the fierce competition among banks, struggling to expand their customer base. Nowadays the tables have turned with bank officials threatening leaseholders to impound their vehicles once they fail to pay their due installments on time.

Banks now focus more on corporate lending and have reduced their exposure in the consumer banking and the SME sector. The market share of the consumer-banking sector has dropped to 12.1 from 14.6 per cent in 2008. Without a formal risk assessment procedure, banks are now reluctant to hand over zero meter cars to just anyone who walks in.

Auditors classify NPLs into four broad categories namely ‘other assets, especially mentioned (OAEM), sub-standard, doubtful and loss. OAEM, the safest category of doubtful debts, has the lowest probability of default on part of the borrower. It refers to borrowers who have the ability to meet their principal as well as interest payment obligations, but there might be certain inauspicious circumstances in which the borrower might not pay back.

The sub-substandard loan encompasses borrowers who might pay back the outstanding amount partially, whereas doubtful borrowers might not be able to pay back a major portion of the debt, despite a guarantee provided by them. Borrowers falling within the “loss category” are highly unlikely to repay after all the necessary legal procedures have been carried out.

Owing to a change in prudential regulations by the SBP in 2007, banks were required to enhance their provisioning against NPLs. Approximately 76 per cent of large size bank’s NPLs are now provided for. For medium size banks, the ratio is close to 78 per cent, whereas small size banks , the ratio stands at 76 per cent The loan provisioning requirements were made stringent by the SBP so as to create an adequate cushion to withstand any potential credit adversity. This increase in provisioning against so-called “low quality assets” has led to a major plunge in the bank’s reported earnings.

The market capitalisation of the banking sector, which is the most heavily weighted in the stock market (23 per cent), recently fell by 70 per cent to Rs424.53 billion. The portfolio risk of the banking sector remains quite high due to its staggering exposure of Rs50 billion in the stock market.

The Credit Information Bureau (CI) set up in 1992 to assist financial institutions in arriving at the prudent lending decisions and averting defaults. Lending institutions are now required to submit detailed monthly reports to the CIB, which apparently offers online reporting facilities as well. The reports contain detailed information about the lending institution’s borrowers and pinpoint any incidence of late payments or defaults by the respective clients. This reduces the likelihood of other banks catering to the needs of a borrower with a bad credit history.

But despite the presence of the CIB, NPLs have witnessed a significant upsurge. The CIB’s limitations need to be addressed. A large number of borrowers still remain untapped due to the minimum loan requirements of Rs500,000 for reporting purposes. Hence, the consumer, agriculture and SME sectors still escape unreported.

While considering the positive trend in NPLs, the floor should be removed by the CIB or set at a level that aims to scrutinise borrowers within the consumer, SME and agricultural side of the business. Currently 41 commercial banks , eight DFIs, 16 NBFCs, nine investment banks, 18 modarabas, five micro finance banks and three mutual funds report to the Credit Information Bureau.

As the competition for deposit mobilisation rages amongst banks and with substitutes such as NSS, banks continue to benefit from high levels of banking spread (7.6 per cent), depicting that the rising cost of deposit mobilisation is passed on to the consumers. The monetary policy review is round the corner and the forthcoming trend in NPLs is likely to be determined by the future course of policy rates. Banks should primarily focus on asset (loan) quality rather than increasing their margins.