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Bank profits and long-term risks

November 04, 2012

Pakistani banks continue making huge profits, recording since the global financial crisis 2008-09, a growth rate higher than in those of many regional countries, according to local bankers.

Shareholders have got dividends/capital gains and bank employees profited from the profitability through increase in salaries and perks. Enhanced liquidity with banks has enabled the government and state-run units to sustain a high level of borrowing.

The central bank has earned money from banks through lending of short-term funds and its profits have contributed to government’s non-tax revenue.

But for the private sector, banks’ profitability is not much of good news. Banks’ lending rates have not fallen fast enough to provide impetus to a vast number of private sector enterprises to make investments. A majority of depositors too continue to get low returns though banks are bound by the central bank to pay at least six per cent return on PLS accounts. On balance, something is wrong somewhere and that needs to be identified and fixed, if conventional (intermediation) banking  business is to thrive on a long- term basis

A random scanning of the financial results of banks reveals that share of interest income in banks’ total profits remains too large and that of non-interest income too little.

This is despite a welcome increase of 22 per cent in non-interest income of 10 out of 19 listed banks in nine months of this year.

Second, banks’ profitability is largely anchored on investment in government securities despite easing of the monetary policy which has lowered their net interest margins.

Third, a handful of large commercial banks continue to dominate the financial market, making it too difficult for competitors to deviate much from the trends set by them.

According to published financial results of all 19 banks listed on stock exchange, their combined net profits jumped 24 per cent from a year-ago period to Rs93.7 billion in nine months of 2012.

Among them, net profits of six major banks at Rs75 billion accounted for 80 per cent of the total net profits of all listed banks.

And the after-tax profit of six major banks, as a group, exhibited 17 per cent year-on-year growth. Such is the domination of large local banks on the overall banking industry. A random scanning of the financial results of banks shows that they earned most of their profits through interest income.

Barring a few, most banks, both listed and unlisted, reported low advances to deposit ratios. So, where their profits originated from if their lending volumes were not that big? Investment in government papers, of course. Most banks reported faster expansion in investment than in their net advances. One big exception was the National Bank of Pakistan whose investment declined by 4.4 per cent and net advances grew by 11 per cent between January and September.

One of the reasons for increase in banks’ net interest incomes is a not-so-fast buildup of bad loans. In June 2012 net NPLs (non-performing loans) to net loans ratio just inched up to 6.15 per cent from 5.71 per cent from in March. Data for bad debts as of September 2012 is not available but bankers say they haven’t seen any unusual growth in bad loans.

However, a slow expansion in bad loans is also indicative of a dangerous underlying trend. “Lending to private sector businesses has been very low and much of the credit off-take under the category of private sector credit has gone to the non-bank finance companies,” points out a central banker.

“Private sector businesses are retiring loans and banks’ lending to SMEs (small and medium enterprises) and consumer sector is not picking up. Traditionally these sectors have remained more prone to loan defaults. That’s possibly why overall stocks of bad loans are not expanding rapidly.”

According to SBP data, banks’ net lending to private sector businesses have rather declined by Rs107 billion between January and August this year. More recent data is not available. On the contrary, their net lending to the NBFCs has increased by Rs116 billion during this period.

For last few years, banks have remained over-exposed to investment in government securities which has already crowded out the private sector. The emergence of this relatively new trend of lending more to the NBFCs than to private sector businesses carries more risks for long-term growth of banks’ intermediation business.

Since the composition of financial sector is such that financial groups own stakes not only in banks but also in NBFCs, lending by banks to NBFCs can often obscure weaknesses of borrowing entities belonging to the same financial group. Besides, since financial business, be it of banks or of NBFCs remains vulnerable to almost identical set of market shocks, any hit taken by banks or NBFCs is more likely to affect the other very quickly.

“It’s always desirable to spread banks’ market risks as widely as possible,” insists head of credit division of a bank. “When a bank’s lending is diversified, into as many areas of economic activity as possible, its market-related risks are manageable.”

Bankers say that in line with the results seen in nine months of this year, the fourth quarter would also not be much different.

But they say that net interest margins may continue to decline, as they did during the third quarter, with the pass-on of monetary easing in August and reinforced in October.

They also say that one percentage point increase in minimum return on saving deposits from five to six per cent, effective in May this year, may further test their ability to keep interest incomes high.

Some of them admit, however, that higher demand for bank credit after easing of interest rates, and possibly large volumes of banks’ lending to the private sector may compensate, to some extent, shortfalls in interest income under falling interest rates environment.