KARACHI, Aug 16: Bad loans of the banking system showed no big change in the April-June 2004 quarter and remained almost intact at the end-March level of Rs220 billion. But volumes of bad loans net of provisioning declined and cash recoveries went up during this period.

Data released by the State Bank put total non-performing loans (NPLs) of banks and DFIs at Rs220 billion at the end of June up very slightly from Rs219.7 billion at the end of March 2004.

But the data show that net NPLs or NPLs net of provisioning of all banks and DFIs fell to Rs71.3 billion from Rs72.9 billion during this period. NPLs or bad loans are the loans the principal or markup or both of which remain unpaid for more than 90 days.

At end-June all banks and DFIs also reported Rs7.114 billion cash recovery up from Rs5.895 billion at the end of March 2004. Whereas the volume of bad loans remained almost unchanged at Rs220 billion at the end of June a decline of Rs1.6 billion in bad loans net or provisioning indicates that the banks and DFIs were more careful in credit administration in April-June quarter than in January-March this year. An increase of Rs1.219 billion in cash recovery during April-June quarter also reflects improved efficiency of banks in terms of managing bad loans.

What is more important is that net NPLs as percentage of net loans fell substantially at the end of June from where they were at the end of March. Net NPLs of all banks and DFIs combined fell to 5.4 per cent of net loans (or total loans minus provisioning) at end-June from 6.3 per cent at end-March this year.

The above statistics show that banks and DFIs are gradually improving upon their professional skills to manage bad loans thereby creating space for themselves to lower lending rates without necessarily slashing already low deposit rates.

Deposit rates have not only turned negative but touched such low levels that banks may face difficulty in mobilizing deposits in future. Weighted average return on fresh deposits (excluding those carrying zero return) stood at 1.99 per cent in June 2004 against the year-on-year CPI inflation of 8.45 per cent during that month.

Bankers say matching weighted average deposit rate with the rate of CPI inflation or inflation measured by Consumer Price Index is not fair. They say that this rate should rather be compared with the weighted average yield of one-year treasury bills.

By the end of June weighted average yield on one-year bills was 2.19 per cent - only 20 basis points above the weighted average return on fresh bank deposits (excluding those carrying zero return).

Bankers argue that when the government itself is offering a highly negative real rate of return on treasury bills how banks can give deposit rates that can match inflation.

"That is not possible for any banking institution anywhere in the world - no matter how much efficient it is," says president of a big local bank. Bankers also say that expecting an inflation-matching return on bank deposits at a time when the average lending rate is below inflation is not a realistic approach. (Weighted average lending rate on fresh loans made in June 2004 was at 5.14 per cent). This argument seemingly carries some weight.

But one should not forget the fact that investment in treasury bills is the safest way of employing surplus funds for banks and that professionally stronger banks employ funds into a well- diversified portfolio earning much higher returns than on T- bills. That coupled with their ability to keep operational cost in check enables them to offer a higher return to depositors.

That is where NPLs come into picture. The lower the net NPLs of a bank the greater it creates room to keep operational cost within limits. That in turn enables the bank to offer a higher return to depositor without necessarily increasing its lending rate - or lower the lending rate without slashing deposit rates.

That the net NPLs of the banking system as percentage of their net loans has come down from 6.3 per cent at end of March to 5.4 per cent at end of June 2004 shows that the system as a whole has achieved this efficiency to some extent.