Banks need to shift gears

In the race of the financial sector growth and evolution, the discontinuity and unpredictability of government policies has kept Pakistan far behind other developing and emerging economies. Unlike others, the absence of debt capital markets and the natural death of Development Financial Institutions have virtually shifted all the financing needs and saving instruments on the plates of commercial banks.
The commercial banks have made windfall gains amid privatisation of the big banks, emergence of new players, and growing interest of foreign players during the boom days of the last decade.
But nationalisation has its hangover; the banks have indulged into 'lazy behaviour' due to a host of reasons including the monopoly of big banks, excessive prudence of foreign banks, and lack of initiative to find a niche on part of the smaller players.
Lack of awareness in the masses as well as religious reasons have helped the big banks raise low cost deposits. Over 85 percent of bank deposits are of less than one-year maturity, which doesn't allow banks freedom to go for long-term project financing.
The sticky nature of those deposits facilitated the banks to finance -- even 20-year projects in some cases -- the expansion seen in the last decade or so. However, infrastructure financing that requires public private partnership and long-term funding from the DFIs or direct fund raising from capital markets largely remained absent.
This problem mainly stems from a lack of funding avenues, the absence of political will to reform the financial industry and the dearth of innovation.
Since the infrastructure, including power and industry supply, could not match the demand of the boom era, the output gap expanded, to eventually be filled by imports. That triggered the worst economic downturn in the country at a time when the world also faced a dreadful recession.
The last two years of crises in Pakistan primarily emanated from fiscal issues and myopic government policies. Had we had strong and sophisticated financial intermediation, the gravity of the crises could have been less.
More than half of the banks' earning assets still revolve around a few big names in the corporate sector. This behaviour not only keeps corporations from directly going to the savers, but it also leaves the small and medium enterprises largely out of the equation.
Another problem seen in the booming days of the last decade was the lack of experienced bankers at the helm of affairs. The lack of domestic banking experience in the private sector gave the employees of foreign banks - especially the Citibank - almost an overnight jump, as local banks paid hefty premiums to get the right man in.
These ex-Citi bankers attempted to replicate the Citi's global banking model of programme lending into the consumer sector and largely bypassed the SME segment. A few even tried the score-model, bypassing the Know Your Costumer model that is more applicable in Pakistan's SME sector.
While this worked well in an upward economic cycle when inflation was low and growth was high, it fell like a pack of cards as the economy took a U-turn in the rising interest rates scenario.
Bad loans started mounting and are still on the rise. While the banks are left with a sour aftertaste of aggressive lending to the consumer segment and advances to SMEs, they are even becoming shy of lending to the big names after a few names went down with the economic downturn.
Then comes a new player in the equation, the government, whose growing needs and sovereign nature made it the biggest occupant of the assets side of banks' balance sheets. With low costs of deposits, big banks started enjoying decent spreads in facilitating short-term government borrowings, an ideal case in the rising interest rate scenario.
Whatever remained was taken up by quasi-fiscal operations in the form of power sector financing to plug the circular debt and commodity operations for procurement of food commodities by government agencies.
This is highly inefficient, as circular debt financing is done merely to plug in the difference between the cost and the recovery of power generation and distribution, while the financing of wheat stocks by the government is clogging the liquidity in the system.
The banks demanded Kibor plus three percent on commodity financing, as they knew that at the time of repayment, the loans would be rolled over. In essence, it meant long term lending to the government.
The stuck liquidity is forcing interest rates upwards and making it even harder for the private sector to borrow. At the same time, lack of consistency of government policies as well as the bleak law and order situation is also keeping private corporations at bay from initiating new projects or expansions.
At this juncture, due to the growing fiscal deficit amid lack of financing avenues and tight monetary policy, the banks' focus on government papers is likely to continue. With the likely passage of the SBP Act, the government will have to reduce its Rs1.4 trillion central bank's borrowing to10 percent of its tax revenues in five years.
This means an average offloading of Rs230-250 billion yearly is on the cards for the next five years, which would significantly increase the government's reliance on commercial banks. Thus, although the economy is expected to regain its course towards recovery, the crowding out of private credit is imminent.
It's going to be a huge challenge for the State Bank to device a policy for liquidity management as well as reduce friction for private lending. An out-of-the-box solution is required to solve this puzzle.
It is pertinent to note that this challenge is confined to only corporate lending and trade financing; to ensure commercial banking reforms to tap the unbanked private savers and broad base the lending structure towards long-term financing, there are other serious challenges too.
The SBP has to devise a combination of administrative measures and incentives to dilute the stronghold of the big five banks and concurrently entice small and medium sized banks to create their own niche. Today, most banks, irrespective of their size, are in the same business of lending to the government and running after a few big corporate names.
The existing banking model makes sense for giants with very low cost of funds, but for tiny players, the cost of funds is high, so their profitability is squeezed in competition with big players.
Some banks are even marked with negative spreads. This cannot continue for long, some are merging and a few are available for acquisitions. However, it is hard to find buyers for these ailing banks. They have to create a niche to survive; for example, becoming a regional bank, an SME bank or a specialised agri bank are just a few of the options.
In recent years, we have seen two banks jumping on the ladder to become medium-sized banks with a focus on trade finance and warm services to attract customers. Another merged entity of three small banks is working on the same model. Then, a long existing foreign bank, after being badly hurt by its aggressive programme lending, is now focusing on gaining dividends from its reach in over 100 countries.
At the same time, the development of a corporate debt market is imperative. The SBP in coordination with the SECP should incentivise corporations to bypass the intermediation role of commercial banks for their financing needs.
There is a need to separate investment banking from the arm of commercial banks as investment banks, being independent identities, would be in competition with commercial banks for finding their niche and would be instrumental in the development of the corporate debt market and listing of new entities in the equity market.
This will sow the seeds for the development of venture capital firms and private equity funds. It would also foster entrepreneurship in the country - which was a major stepping-stone for fast track growth in India and China.
The transition to a knowledge-based economy surely needs supportive government policies with more budget allocation towards education; but nonetheless, the financial sector must also play its role.
The success of Engro's Rupiya may entice other big names to go directly to savers for their financing needs. Such practices will push the banks to be innovative and to tap the SME sector and consumers more.
But it will be unfair to put all the blames on banks, as slow enforcement of foreclosure laws dilutes the pressure on borrowers and make banks shy of aggressive lending in consumer and SMEs.
SBP should join hands with the government to work on better laws to safeguard the interest of banks in case of defaults. Banks should have the ability to pass on the business to new people in case of failure of one to repay.
Moreover, better zoning and land laws should be in place to tap the much-needed mortgage financing. High interest rate is another impediment for house financing to meet the rising demand for the low and upper middle class. Refinance facilities with IFC and other multilateral agencies should be obtained for adjusting the interest costs in line with the rental yields.
These are medium to long-term solutions. In the immediate short-term, given the constraints of poor law and order situation and growing government needs on commercial banks, the concentration should be towards reaching the untapped areas.
Floods should be seen as a window of opportunity to tap the growing rural economy and the SBP is cognizant of it, as it's working on Export Refinance Schemes in the flood-hit areas and providing first loss guarantees to lenders advancing credit to the flood-hit areas. The focus is to inculcate a culture amongst banks to penetrate the rural areas.
But then again, for this idea to flourish, documentation of the economy is imperative. Although the government's efforts under the umbrella of the IMF to implement RGST will go a long way in documentation of the economy, other technological and institutional upgradation for land titles will help in giving comfort to lenders and lower the borrowing cost as well as expand banking in the unbanked areas.
A marriage of telcos with banks is the need of the hour to ensure service delivery in small far-flung areas financially viable for commercial banks.
Branchless banking is the future of banks - already there are a few products in the market including easypaisa and UBL Omni with many other products of other banks in the pipeline. With the passage of time, the branchless banking should also offer other products such as consumer assets while catering to the S part of SMEs segment at the same time.
The government and the SBP should work closely to make agri lending viable for banks by eliminating the role of middle man - arthi. Warehouses should be made available and commodity exchanges should be established to have the requisite documentation and hedging instruments for banks to cover risks. Crop insurance should follow.
In a nutshell, the concept of financial inclusion has to be flourished. The vertical integration of products including deposits, lending and insurance should reach the far-flung areas. On the other hand, infrastructure-financing companies should follow the public private partnership model; they should acquire long-term financing from international agencies to provide adequate infrastructure domestically.
Then again, the biggest impediment to Pakistan's growth is the discontinuity and unpredictability of government policies. Yet, there is hope that the democratic process will flourish and the political goals of various parties will converge with the economic needs of the masses.
The writer can be reached at [email protected]