Ishrat Husain: Sustainable growth in the financial sector of Pakistan
Address by Mr Ishrat Husain, Governor of the State Bank of Pakistan, as chief guest at the
Symposium Organized by the Public Relations Management Group, Karachi, 29 April 2005.
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It is pertinent to ask whether the reforms brought about in the financial sector of Pakistan will persist
generating sustainable growth in the sector or quickly dissipate.
In my view there are at least eight factors that attest to the sustainability of growth in the financial
sector. Of course, the sector cannot be divorced from the overall external, domestic and
macroeconomic conditions. If there is a breakdown in political stability or macroeconomic situation is
under stress, then these factors will not be operative. This analysis assumes stability, continuity of
good policies and good governance. What are these factors?
First, capital base of the banks has been strengthened by raising the minimum capital requirements
from Rs. 500 million to Rs. 2 billion. This will be raised further in the coming years. In addition, the
capital adequacy ratio which reflects the amount of capital to finance the risk weighted assets is now
at about 11 percent for the banking industry as an average against the minimum requirement of
8 percent. As the banks mainly use the depositors' money to take risks they should also have their
shareholders' money at stake too. This high capital adequacy ensures that the bank management
exercise caution and prudence in granting of loans.
Second, the quality of assets of the banking system has improved during the last few years. Gross
Non performing loans to Gross advances for the commercial banks have come down from 25 percent
to less than 10 percent while the provisions held by the banks against these NPLs cover about
70 percent of gross NPLs. Consequently, the net NPL to net advances ratio has shown a remarkable
decline to 3 percent while is comparable to international standards. The flow of NPLs has dwindled to
less than 5 percent that means that 95 percent of the loans in banks' portfolio are being fully serviced
on time.
Third, the earnings of the commercial banks have risen not because they have invested in stock
market or real estate but because healthy competition and restructuring have resulted in efficiency
gains. The spreads between the deposit and lending rates now range between 3.5 to 4.5 percent
compared to 7.5 to 8 percent five years ago. The spreads have declined because the drag of NPLs
has disappeared, the corporate tax rates on the profits of the banks have been lowered from
58 percent to 41 percent and 35 percent in the next two years and excess labor has been eased out
through golden handshake schemes in the three major banks - NPB, HBL and UBL. Cost - Income
ratios have therefore fallen from 74 percent to less than 60 percent and administrative costs range
between 2.1 to 3.2 percent. The stable earning stream from core banking business allows the banks to
build up reserves for facing unforeseen contingencies and strengthens their balance sheets.
Fourth, the accesses to banking services have been broadened to a much wider customer base
particularly the middle and lower middle income groups. No country can aspire for sustainable and
equitable growth in absence of a strong and healthy middle class. In Pakistan, the banking system
was intermediating the savings of millions of depositors primarily to fund the fiscal deficit and the
losses of the public sector, to meet the working capital of 200 top named companies and to engage in
letters of credit for business and international trade. The number of active borrowers was limited to
less than half a million at best. By allowing the banking system to offer new products and services
such as agriculture credit, SME financing, mortgage loans, automobile leasing, personal loans etc. a
new vista has opened up. Commercial banks that were always hesitant to channel credit to agriculture
sector are now the single most source of agriculture financing. This year almost 1 million households
will receive about Rs. 100 billion of loans for agriculture. Similarly, the Khushhali Bank, PPAF and
other microfinance institutions will reach out to half a million households providing them small
unsecured loans ranging between Rs. 5,000 to Rs. 25,000. The beneficiaries of these loans are
mainly the landless, the women and other poor classes who never had access to bank financing.
Salaried classes have also begun to leverage their incomes by receiving personal loans the
installments of which are deducted from their monthly pay checks. At least another half a million
families have availed of these loans. This broadening of access not only eases the credit constraint
faced by a dynamic segment of the population and transfers purchasing power in their hands but also
diversifies the risk for the banks and allows them to earn a decent return on their loan products. This
enhanced purchasing power in the hands of a large number of families stimulates aggregate demand
in the economy, helps in the expansion of production of manufactured goods and in the higher growth
of the economy.
Fifth, with the privatization of nationalized commercial banks the role of the regulatory and supervisory
authorities has also changed. A strong regulator is needed to act as a vigilant watchdog on the banks
and banking industry as a whole. Prudential regulations and norms and their effective enforcement is
one of the potent instruments to perform this function. But ensuring good corporate governance is
another way to do so. The SBP has laid down fit and proper criteria for the appointment of the Boards
of Directors, Chief Executives and Senior management of the banks. Those who meet this test can
hold the office for the prescribed tenure but in case there is deviation and the appointees do not meet
the test the SBP advises the banks to replace the individuals concerned by more appropriate persons.
In my reckoning 50 percent of the job of the regulator is completed if the right persons are appointed
and the corporate governance guidelines are observed in letter and spirit.
Sixth, there have been certain apprehensions expressed about the risks to which the banks have been
exposed or will be exposed in the future in light of the rising interest rates. There are two strands of
criticism on this count. There are those who believe that there will be more defaults on consumer loans
as interest rates go up. It is always true that the default rate will be higher under a rising interest rate
scenario compared to low interest rates. But for the last five years the banks have been asked to
earmark reserves of 1.5 percent against their secured consumer loans and 3 percent against
unsecured loans in their portfolios. This pool of money will enable the banks to deal with in the event
they are stuck with higher defaults. At the same time the repossession laws have been strengthened
and repossession of automobiles or houses has become much easier for the banks and liquidate their
collaterals against which the loans have been given.
A second criticism is that the banks are fuelling the speculative activities such as stock market share
trading and real estate purchases. The banks have been restricted by the SBP and their total
exposure to shares can not exceed 20 percent of their equity. If we assume, for the sake of argument,
that all the banks have collectively used up this maximum limit of exposure their investment of the
banking sector in shares would be small - about Rs. 32 billion. This accounts only 1.6 percent of the
total assets of the banking system and it can be seen that it does not pose any serious risk to the
bank.
As far as real estate is concerned, the banks cannot finance purchase of plots of land and only against
housing. The direct lending for mortgage is miniscule but indirectly the banks can be put to risk
because of inflated values of property held as collateral. The SBP insists that only the forced sale
value and not the market value should be taken into consideration for valuing the collaterals. This will
save the banks from downward movement in the market prices of the real estate.
Another risk mitigating measure taken by the SBP is to extend the coverage of all loans - corporate
and consumer - in the Credit Information Bureau. This real time on-line information service which is
currently limited to the corporate borrowers will enable the banks to appraise the credit worthiness of
prospective consumer loanees, determine their aggregate repayment capacity and verify the credit
history before approving the loans. Thus, a card holder who already has four to five credit cards and
reached his borrowing limit will find it difficult to get a card from another bank.
Seventh, the human resource base of the banking system is being upgraded. Emulating the example
set by the SBP in recruitment of new employees through merit based competition, other banks have
also started following the same system. I am, therefore, sanguine that the new breed of bankers will
be infused with professional skills. We have formed a task force consisting of the HR Managers of all
the banks and mandated them to come up with industry wide standards for training, promotion,
compensation and benefits, severance and continuing professional education. The banks have to
move away from the old paradigm of seniority as the sole criterion for career advancement. In future
the promotions should be based on upgradation of skills and demonstration of performance. In a
knowledge-based economy and a service-oriented sector, it is absolutely imperative that investment in
human skills is given utmost priority.
Eighth, five years ago the technological base of the banking industry was not even at a rudimentary
stage. The SBP embarked upon a Technology upgradation project which will be completed this year
after five years' serious efforts. The banks have also followed the lead and from almost a scratch we
have more than 800 ATMs and almost half of the branches nation-wide are connected on-line. By the
end of 2005 it is expected that most branches will have on-line and internet banking facilities. The Real
Time Gross Settlement System (RTGS) will allow inter-bank transfer of funds from any place in the
country thus increasing the efficiency and providing convenience to the customers.
The cost of transactions will be reduced significantly once the ATM network and on-line banking
become firmly entrenched. It is estimated that the average cost of processing a cheque is around Rs.
50 while that of ATM withdrawal is Rs. 15. Thus, the cost savings will result in further efficiency of the
banking system and increased volume of business.
Conclusion
The above analysis shows that the fundamental reforms carried out in the financial sector have
brought about significant changes in the structure, processes, regulation, technology and human
resource base of Pakistan's banking sector. The reforms have initiated a virtuous cycle of economic
growth which is pro-poor. These changes and their future continuation provide the foundation for
sustainable growth in the financial sector and the virtuous cycle in economy.