Govt papers SBP concerned over banks' rising investment

KARACHI: The State Bank of Pakistan (SBP) has shown serious concern over the rising banks' investment in government papers, and termed this trend 'unsustainable' for the banking industry. According to SBP, this is also receding the banks' role as financial intermediaries, particularly when viewed in terms of socially and economically desirable allocation of credit.

According to SBP's 'Financial Stability Review' (FSR), issued on Friday, the government's reliance on the banking sector heightens the concerns about private sector crowding out, and poor credit off-take by the private sector has some other causes as well that include severe energy crisis and challenging economic environment. The first halfyearly Review said that credit risk remained a major challenge as banks accumulated Rs. 31 billion of fresh non-performing loans, pushing infection ratio from 14.7 percent to 15.3 percent, the Review said, adding that public sector commercial banks and mid-sized local private banks appeared more vulnerable to higher credit risk.

According to he review, the banks' profits before tax were up by 31 percent during the first half (Jan-June) of 2011 to reach Rs 77 billion. However, the report showed that source of profits was shifting away from interest income through advances to investments in government papers, and returns from investments in government securities account for almost 30 percent.

"This trend is neither desirable nor sustainable, first, because it compromises intermediation function, and second, since any sharp cut in discount rate can discernibly knock these profits", the SBP pointed out.

Incidentally, the SBP has cut its discount rate by 200 basis points since June 2011. While the immediate effect on banks' balance sheet may not necessarily be negative because of revaluation gains, it would reduce future interest income from government securities, a key earning source in recent times, the report said.

During the half year under review, government's dependence on the banking system remained strong, amid poor tax collection, as tax-to-GDP ratio stood at 9.4 percent, and steadily diminishing contribution of the external funds in deficit financing. External funding stood at 9 percent in FY11 compared to above 50 percent during FY01-07.

Furthermore, from Nov 2010 onwards, the commercial banks became a major source of deficit financing as the government shifted its borrowings away from the central bank. While this shift somewhat helped the government keep its borrowings from SBP within agreed limits, it is likely to aggravate the budget deficit as return on government securities is now being earned by commercial banks instead of the SBP, the Review said.

It said that government borrowings from the central bank help the SBP to earn interest income and this translates into higher profits for SBP which are ultimately transferred to government as non-tax revenues. In case of interest income accumulated by commercial banks, the benefit to government is only partial, dictated by effective tax rate on banks' earnings.

As a consequence, banks' appetite for investment in government papers continues unabated, pushing the share of net investments in banks' total assets to 34 percent, highest in a decade. Unsurprisingly, the share of net advances has experienced a concomitant drop, further sliding down to 43.9 percent by June- 11.

By the same token, it underscores banks' growing risk aversion towards private sector credit which is ostensibly riskier and less attractive when risk-free investments offer decent returns. In strict sense, conversion of deposits into any type of lending is intermediation, whether the ultimate borrower is government or the private sector. However, lending to private sector is discernibly productive as it helps promote economic activity and job creation, the report said.

According to the review, other risks to the banking system remain well contained. In fact, liquidity position of the banks has been comfortable in general, with industry maintaining excess liquidity than statutorily required, thanks to growing share of investments in banks' portfolios. Further, the increasing share of long-term deposits in the funding mix kept funding liquidity risk at bay. Market risk remains subdued, amid relatively stable exchange rate and interest rate during the period, notwithstanding the lacklustre performance of the equity market.

It said that assets of Pakistan's banking system soared by 8 percent, or Rs 577 billion, to Rs. 7.7 trillion during the first half of calendar year 2011. This surge in banks' total assets, both in absolute and growth terms, was the most significant since 2007 and support by a robust increase in investments, overwhelmingly in government papers, as 90.6 percent of incremental investments during H1-CY11 were in government papers.

In addition, deposits increased by 9.4 percent, registering the highest halfyearly growth during the last four years, it said, adding that net investments, with an increase of 22.4 percent during the first half of 2011, markedly outpaced the anemic growth of 1.04 percent in net advances.

The first halfyearly Review said that banks' profits before tax were up by 31 percent during the first half of 2011 to reach Rs 77 billion, with Return On Assets (ROA) of 2.1 percent (1.8  percent in June-10) and Return On Equity (ROE) of 21.9  percent (17.7 percent in June-10). During Jan-June 2011, banks remained fairly liquid on the back of growing share of investments in government papers, it said, adding that further banks' capital adequacy ratio also observed improvement, reaching 14.1 percent by June-2011.

It said that concentration in profits dropped (share of top 5 banks down from 95 percent in Dec-10 to 78 percent in June-11), ensuring that even smaller banks had a share, albeit marginal, in industry profits. Further, growing profits also helped reduce the number of loss-making banks, from 17 in June-10 to 8 in June-11,' it said. However, the Review cautioned that source of profits is shifting away from interest income through advances to investments in government papers. Specifically, returns from investments in government papers now account for almost 30 percent of banks' interest income, up from 24 percent in June-2010, it added.

The Review stressed that there has been growing evidence of banks' flight towards quality as net investments, mainly in government securities, now constitute around 34 percent of banks' assets compared with 28 percent in June, 2010. "The share of net advances has witnessed a concomitant drop, from 47.6 to 43.9 percent during the same period", it said, adding that unsurprisingly, Advances-to-Deposits ratio further dropped from 63.0 percent in June, 2010 to 56.7 percent by June, 2011.

The Review said that Islamic banking institutions (IBIs) registered 17.5 percent growth during H1-CY11, with bulk of incremental assets channeled into government securities. Islamic banks appeared more liquid, solvent and profitable when compared with rest of the banking sector but faced unique risks like reputational risk and displaced commercial risk, it said.

Referring to other components of the financial system, the Review said that domestic financial markets remained stable during the half year under review, despite some bouts of mild strain. External inflows kept the value of domestic currency almost stable, as the rupee depreciated by a marginal (0.35 percent) against dollar. The capital market managed to post a growth of 4 percent during the half year under review.

The Review said that the asset base of the development finance institutions (DFIs) managed to grow marginally by 4 percent, primarily on account of stronger growth in investments. "Share of advances in total assets remained intact (around 35 percent), though at significantly lower level than what DFIs' nature of business would warrant," it added.

However, the trading volumes and activities in the corporate debt market largely remained low. The derivatives market, on the other hand, shrank further as insipid credit to private sector coupled with stable exchange rate and interest rate environment dampened the demand for new derivative contracts.

The Review said that, in contrast, the mutual funds industry witnessed its revival as the money market investments improved the net assets of the industry by 24 percent in H1-CY11. "The insurance industry witnessed a growth of 16.6 percent in its asset base with the life business experienced a much strong growth (24 percent)," it added.

During the half year under review, the payment systems functioned smoothly, with amount transacted through retail payment system growing by 14 percent (YoY) against 11.6 percent in the corresponding period of last year. In terms of volume, share of e-banking transactions gained momentum, reaching 42 percent by June-11, the Review added.

It said that in the area of branchless banking, Pakistan is experiencing a rapid expansion, with four banks offering services through various operational setups. As more banks are planning to enter this growing segment, there is strong potential to significantly improve financial inclusion in the years ahead, it added.

While discussing the future outlook, the FSR said that a mild pick-up in private sector credit is likely as the borrowing cycle of some key industries resumes, though receding commodity prices would keep the growth in check. Further, the challenging business environment in general and banks' risk aversion amid high credit risk would limit the possibility of a perceptible reversal in asset mix away from the government papers, it said.

"The current monetary policy stance would make banks' asset selection challenging in the months ahead; banks will either have to live with lower returns on their investments (a key contribution to profits in recent times) or to aim for greater private sector credit, which in a difficult economic environment, would truly test their ability to adroitly manage an already high credit risk,' the Review said.