That was the time when banks gave advances and loans not only to the traditional borrowers but also ventured into the new areas such as consumer-financing and housing etc.
The total advances of banks increased rapidly and touched the highest level of Rs2.5 trillion in June, 2007. When banks have surplus liquidity, they are less vigilant while making advances. This happened with the US banks, having plenty of deposits from oil producing countries and eager to advance the loans to Mexico, Brazil and other Latin American countries, irrespective of the capacity of the debtor countries to repay the same.
At the end, the debtor countries defaulted and IMF and other international finance institutions rescued the whole system from collapsing. Recent sub-prime mortgage crisis of the US is also the result of cheap and easy credit to the housing sector. Although Pakistan’s financial system is not as pervasive, sophisticated and diversified as its crisis may engulf other sectors of the economy, yet many analysts had earlier advised banks to be more prudent while making advances.
This was necessary at that time when the banking sector was just coming out of the crisis. Major commercial banks were suffering from the burden of infected loans. In 2001, the ratio of total non-performing loans (NPLs) to advances was 23.4 per cent which declined to 7.2 per cent in March, 2007. The banking sector improved significantly in this period and developed a strong capital base and resilience against adverse shocks.
This may be seen from the two per cent return on assets (RoA) and 20 per cent return on equity (RoE) in September 2007. However, the advice regarding vigilance was not heeded, both by bankers and the policy makers. As the economic conditions changed and the central bank adopted the tight monetary policy by raising the discount rate with regular intervals, the situation began to unfold.
According to a report, profits of the listed commercial banks have declined in the first half of 2008 by 20 per cent to Rs34.4billion from Rs43 billion in the same period last year. This is despite the fact that not only the interest rates on loans but the spread have also increased manifold as banks have not increased the rates on deposits accordingly. The widening spread had increased the banks’ earnings.
Apart from this, despite the slowdown in the consumer credit, the overall demand for credit of private sector is also strong. This may be seen from the fact that the cumulative growth in private sector credit in the fiscal year ended June, 2008 was 14.9 per cent, 2.5 percentage points higher than that of in the corresponding period of the previous year. Thus the reason of reduction in profits lies somewhere else.
Investment, after advances, is the second largest component of assets of the banking system. In January-September 2007, the investments recorded an increase of Rs476.1 billion which was 80 per cent of the total increase in assets in that period. Although most of these investments are in government securities but a significant share is also invested in shares of different companies.
As on December 2007, out of the total outstanding investments of Rs1205 billion about Rs106 billion or eight per cent of the total investments were in shares. The sharp decline in the value of the shares in the recent past has affected adversely the earnings of banks. Another main factor which has hit the profits of banks is the increasing trend of NPLs.
The policy makers admit that this is due to the extraordinary credit expansion in the private sector in the last few years. In 2002, the NPLs of the banks were Rs231.5 billion which declined to Rs173.2 billion in 2006 but rose again to Rs187.4 billion in 2007. This trend has continued which may be seen from the fact that the ratio of NPLs to total loans further increased to 7.8 per cent at the end of March, 2008.
The corporate sector has the largest share in the growth of NPLs. The ratio of NPLs of these loans to total corporate loans increased from 6.7 per cent at the end of March, 2007 to 7.8 per cent at the end of March, 2008. However, the quality of the consumer loans appears to have deteriorated most. The gross NPLs in consumer loans category at end FY 2007 were more than double the same at end of FY2006. As banks have the strong capital base and their earnings both from interest and non-interest sources are still high, the rising trend of NPLs is not creating much problem for them in the short- term. According to an estimate, banks have done provisioning for about 77.8 per cent of total NPLs which is quite significant.
Thus the ratio of net NPLs to net loans is 1.6 per cent which is quite compatible with the ratio of 1.2 per cent of India in 2006. As the provisioning is also an expense, it would affect the income and profitability of banks. Banks are already cautious in giving new loans, particularly to consumer sector.