Moody's Investors Services has changed its outlook for the banking system in Pakistan to negative (B3 negative) from stable owing to slowing of the economy and high exposure to sovereign debt. Moody's in its latest report "Banking System Outlook: Pakistan", states that the banks' operating conditions will be difficult with Pakistan's real GDP growth slowing to 4.3 percent in the fiscal year ending June 2019, down from 5.8 percent in 2018.
The Pakistani rupee has depreciated 30 percent versus the US dollar, interest rates rose by 450 basis points between December 2017 and February 2019, and inflation is rising; all factors which affect business and consumer confidence and the private sector's debt repayment capacities. Tighter domestic monetary conditions - driven by a wide current account deficit and low foreign exchange reserves will weigh on economic activity.
Moody's also points out that Pakistan's banks face the risk of macroeconomic contagion through a range of channels, including: (i) their large holdings of government securities, which cap their credit profiles to the sovereign, and (ii) from the authorities' weakening capacity to support the banks in case of need, as evidenced by the negative outlook on the sovereign rating.
Challenges facing the banks also include the country's low global competitiveness, due to weak infrastructure, institutional constraints and low levels of higher education among the population.
Pakistan's sizeable fiscal deficit could affect development spending and lead to rising arrears, indirectly affecting the private sector. Inefficiencies and weak governance at state-owned enterprises are further constraints.
Susceptibility to escalating political tensions or renewed security unrest could threaten planned investment and undermine confidence. Climate change risk, with both droughts and floods is harming growth in the agricultural sector and rural household spending.
Moody's negative outlook is based on assessment of six drivers: operating environment (deteriorating); asset risk (deteriorating), capital (stable); profitability and efficiency (stable); funding and liquidity (stable); and government support (deteriorating).
High exposure to government securities (34 percent of assets) links banks' credit profile to that of the sovereign, whose credit profile is increasingly challenged. The declining trend in problem loans (8 percent of gross loans as of September 2018) will stall, as challenging operating conditions and structural impediments hamper banks' ability to resolve legacy Non-Performing Loans (NPLs).
The report states that regulatory capital (Tier 1 at 13.2 percent as of September 2018) will remain broadly stable but calculations point to only modest capital buffers. Higher profit retention, hybrid Tier 1 capital issuances and other capital optimization measures will offset credit growth and so support reported Tier 1 ratios.
Profits will increase slightly but remain below historical levels. Profitability will be driven by higher net interest margins (on the back of higher interest rates and rising government bond yields), 10pc-12pc credit growth and lower one-off costs, which will compensate for rising provisioning needs and ongoing pressures at banks' overseas operations.
Stable customer deposits and high liquidity will remain key strengths. Customer deposits make up around 71 percent of total assets, and it is expected that these would grow by 10 percent this year, providing banks with ample low-cost funding. Cash and bank placements account for around 15 percent of total assets, while another 34 percent is invested in government securities offering sound liquidity. The government's capacity to support banks has deteriorated given its high debt levels, but its commitment to supporting the banks remains strong.
Moody's maintained that Pakistan's longer-term growth potential remains strong, despite current pressures and downside risks. Infrastructure investment and significant increases in power supply, partly financed by China's China-Pakistan Economic Corridor (CPEC) project, will address some long-standing economic constraints. Improvements in national security have also filtered through into stronger business confidence.
The new government plans further institutional reforms, which, if effectively implemented, will bolster institutional strength. Higher inflows of remittances, driven by economic recovery in Gulf countries, will also support private spending.
Moody's expects private-sector lending growth of 10%-12% in 2019, despite a 5.0pc-5.4pc fiscal deficit, partly financed by banks. Loan growth and deepening financial penetration will also be supported by state initiatives; National Financial Inclusion Strategy (NFIS) includes initiatives to allow customers to open branchless bank accounts remotely, conduct transactions with mobile phones and introduce low risk accounts with simplified due diligence requirements.
Account holders in Pakistan grew to 21 percent from 13 percent over two years. SME-Authorities aim for SME loans to increase to around 17 percent of private-sector credit by 2020 by setting minimum targets for banks; providing tax benefits, and prudential incentives such as a relaxation of provisioning and capital requirements; Islamic banking- targeting 25pc market share of the banking industry with revised Shari'ah governance framework and initiatives to facilitate liquidity management; promotion of low cost housing-a policy targeting increased housing finance loans through regulatory and tax incentives, and subsidized financing facilities for banks.
Large holdings of the government bonds and loans to public-sector entities weigh on the banks' credit profiles. Specifically, Pakistan's B3 negative outlook suggests decreasing credit worthiness; given heightened external vulnerability risks as ongoing balance of payment pressures erode foreign exchange buffers.
Holdings of the government securities stood at around Rs 6.1 trillion ($49.6 billion) at the end of September 2018. The amount is equivalent to 34 percent of total assets, or 5.4 times the banking sector's Tier 1 capital. Loans to the government/public-sector account for an additional 11 percent of total assets, or 1.8x Tier 1 capital. Moody's expects the government exposure to remain high over its outlook horizon, as Pakistani banks will remain the main source of financing for the government.
Sector-wide NPLs declined to 8 percent of total loans as of September 2018, the lowest since 2008, primarily supported by stronger economic growth.
Loan-loss reserves stood at 86 percent of NPLs. However, it is expected the decline in NPLs to stall. This is due to the slowing economy, a drop in public sector development spending and the potential for government arrears to rise, renewed private-sector lending that could translate into higher NPL formation as interest rates rise, ongoing challenges at some banks' foreign operations, especially those in the Gulf region, high concentration of loans to single borrowers and ongoing anti-money laundering investigations against a large business group (OMNI Group).
Problem loans at Pakistani banks are higher than for most emerging market peers, but improving risk management will help to limit new delinquencies.
Recent regulatory measures include initiatives to facilitate NPL recovery and strengthen bankruptcy law (Corporate Rehabilitation Act), efforts to promote credit culture and improve the availability of credit information so that banks can more accurately assess borrower creditworthiness. In addition to the Electronic Credit Information Bureau (e-CIB), the authorities have granted licences to two private-sector credit bureaus, enhanced macro-level monitoring of large borrowers by the State Bank of Pakistan (SBP).
Pakistani banks reported a Tier 1 ratio of 13.2 percent and equity-to-assets of 7.7 percent as of September 2018, which Moody's consider modest. Adjusting the risk weight on sovereign securities to 100pc from 0pc to better reflect the sovereign's B3 rating, the adjusted Tier 1 ratio declines to 7.7pc.
Moody's expects the system-wide capital ratio to fall by around 40 basis points to 8.1pc from 8.5pc over a two-year horizon, i.e. to end-2020.
Excluding security losses (i.e, assumed expected loss on government securities, based on Pakistan's B3 rating), the capital ratio would be broadly stable. Under Moody's stress scenario, the impact would be extremely severe, leaving the system with a negative tangible common equity equivalent to 13.8% of risk weighted assets at the end of two years.
Moody's expects a slight improvement in profits for 2019, primarily driven by higher interest rates and government yields, which will support net interest margins. Profitability hit a low in Q3 2018 with return on assets at 0.8pc.
Profitability will also be supported by 10pc-12pc lending growth and a drop in one-off costs (e.g. banks incurred significant costs related to pension liabilities in 2018). Profitability growth will, however, remain constrained by higher provisioning requirements; operating conditions will become more challenging for borrowers, energy arrears are rising and loan-loss recoveries are declining, de-leveraging at some banks' Gulf operations, where loan losses have mounted, consolidation of overseas operations and closure of some banks' US operations following anti-money laundering issues, subdued trading gains, extension of special taxation (4 percent "super tax"), rising costs as a result of: (i) investments to strengthen compliance and security infrastructure; (ii) newly introduced deposit insurance fees; (iii) higher minimum staff pension payments (of Rs8,000 a month, with a 5pc annual increase).
Moody's expects deposits to expand by 10pc in 2019, driven by deepening banking penetration in response to network expansion and digitalization.
Pakistani banks to maintain comfortable liquidity buffers; core liquid assets (cash and bank placements) accounted for 15pc of assets as of September 2018; these are complemented by the banks' significant investments in government securities (34pc of total assets), of which around 60pc is in short-term Treasury bills.

Copyright Business Recorder, 2019

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