Syed Salim Raza: Reflections on financial sector dynamics
Keynote address by Mr Syed Salim Raza, Governor of the State Bank of Pakistan, at the
Institute of Bankers, Karachi, 18 June 2009.
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It gives me great pleasure to chair this event organized by the Institute of Bankers and to
share some thoughts with senior bankers and the distinguished personalities attending. I
wish to congratulate all those who have passed the IBP examination and have qualified for
the awards to be distributed today. They deserve much appreciation on their achievement. I
am sure the banking industry will utilize their knowledge for the larger benefit of our society
and economy.
I would like to take this opportunity to share some views on emerging trends in the financial
sector. Even though financial institutions in Pakistan have remained largely insulated from
the shocks of the global financial crisis, we cannot ignore the implications of events which
started in the summer of 2007 in the global financial system. The crisis brought forth the
realization that organizations which are not just too-big-tofail but also
too-interconnected-tofail, are the major source of systemic risk. It reinforced the fact that complete reliance on
mathematical model-based risk management systems is insufficient in assessing the wide
array of risks faced by the financial sector, some of which need a more qualitative analysis
and judgment. Most importantly, it showed how its protracted duration severely impaired the
basic function of the financial sector i.e. efficient allocation of resources in the process of
financial intermediation. As I will elaborate, the regulatory focus in Pakistan has strived to
prevent and mitigate the occurrence of these factors as the financial sector continues to
evolve and progress.
The banking sector in Pakistan has undergone a sea change in the last few years. The
unprecedented performance in terms of profitability, in building up a resilient capital base as
reflected in the aggregate Capital Adequacy Ratio (CAR), implementation of Basel II and
stringent provisioning requirements etc. have all contributed in providing a cushion against
shocks from both the external and domestic macro-financial environment. Banks in Pakistan
have been able to withstand the headwinds from weakening macroeconomic fundamentals
since FY07. Now that the economy is poised for a turnaround, the banking sector has an
even more emphatic role to play in supporting the real sector by meeting its financing needs.
Admittedly, banks face a challenging environment going forward: first, there is increased
credit risk in the industry, a large part of which emanates from the nature of economic cycles.
Credit booms inevitably lead to higher NPLs in subsequent years. The loan portfolio of the
banking sector registered an annual average growth of over 20.0 percent in recent years
(CY02 to CY07). Some correction in the loan portfolio was, therefore, to be expected. Also,
the build-up of macroeconomic pressures which eventually led to a slowdown in economic
growth in FY09 aggravated the increase in NPLs of the banking system. This is a cyclical
process and is expected to stabilize with the improvement in macroeconomic fundamentals.
Sensitivity analysis by the SBP suggests that the banking sector is well placed to withstand
credit risk shocks of a modest nature. The provisioning coverage ratio of around 70 percent
at end March 2009 also shows a prudent and proactive approach towards credit risk
management.
Secondly, competition from NSS instruments offering a relatively higher rate of return has put
increasing pressure on banks' deposit generation capacity. Since the beginning of FY09,
NSS instruments have seen a net inflow of Rs 206.7 billion, as compared to Rs. 86.6 billion
in FY08. On one hand this augurs well in substantiating financial savings and meets the
government's objective of raising funds for deficit financing from non- bank sources.
However it does also imply that banks need to make concrete efforts to ensure sustained
deposit growth by tapping the unbanked market, increasing financial penetration and
facilitating the process of financial intermediation.
Third, given the associated pressure on profitability levels, small banks faced the challenge
of meeting the minimum capital requirements (MCR) specified by the State Bank of Pakistan
in 2008. In response to the challenges in the macro-financial environment, we have
rationalized the MCR and the time period in which it needs to be implemented, thus providing
breathing space to the industry in difficult conditions, fostering competition and a
levelplaying field in the industry.
Notwithstanding these developments, banks in Pakistan are meeting the financing demands
of not just the private sector, but as seen in the recent past, of the public sector enterprises
as well. Private sector credit to GDP ratio has declined from 26.2 percent in FY08 to 20.2
percent by April FY09. Such developments reinforce the need for diversification in the
available financing options. One of the most illustrative examples of the grave implications of
a skewed financial sector is the East Asian crisis, where banks were the predominant
provider of finance. Post-crisis reflection on events brought forth the realization of the
significance of alternative debt markets and in particular, money and bond markets, as a
complementary source of finance. Moreover, the continued integration and deepening of
financial markets is a significant issue for policy makers, and particularly for central banks
entrusted with the formulation and implementation of monetary policy, since well-integrated
and efficient financial markets are crucial in ensuring a smooth transmission of monetary
impulses to the economy.
Indeed, banking sector dominance is an impediment to the fundamental principle of market
competition; it leads to inefficiencies and therefore to sub- optimal outcomes in the loan
market, which may jeopardize the stability of the financial system. Consider the following:
(i) When the banking sector has to face competition from a well developed local
currency bond market, it is forced to improve the efficiency of its operations and
develop corporate financial services beyond primary lending. In Pakistan, the
banking sector faces very little competition from the corporate debt market. Indeed,
extraordinary banking spreads, as witnessed in Pakistan recently, provide some
evidence of the lack of strong competition and efficiency in Pakistan's financial
markets. So our capacity for corporate finance remains undeveloped.
(ii) The short tenor of bank loans, itself a consequence of the nature of banks' deposits
in Pakistan, leads to maturity mismatch issues in the banks' asset and liability
portfolios. This essentially means that long-term funding needs are financed by a
consistent roll-over of short-term loans and in times of tight liquidity, borrowers may
find themselves unable to roll over their maturing obligations. Access to bond
markets then serves the purpose of a complimentary, rather than the alternative
source of finance, as encapsulated in the much cited example of the essential
"spare tyre" that a financial system needs. This is particularly true when a growing
economy like Pakistan needs to raise sufficient funds for financing long- term
infrastructure projects.
(iii) When firms can raise their own funds through the issuance of market bonds, they
are less dependent on banks and therefore not vulnerable to difficulties that banks
might face. This also puts pressure on banks to diversify and widen their portfolio
and service range, as they no longer possess captive clients. Consequently, banks
can focus more on enterprisers in the economy that typically face credit constraints
due to their small size, relatively new stage of development, or simply asymmetrical
information. At present, the banks' loan portfolio is highly skewed towards big sized
loans. Only 0.5 percent of total bank borrowers with loans size of more than Rs 10.0
million take up 71.7 percent of banks' loan portfolio. Among others, this indicates
high concentration risk in the banking sector. Default of any of the three largest
fund-based exposures can cause the aggregate CAR to fall below the minimum
requirements. These risks can be easily managed in the presence of well developed
capital markets.
(iv) One inherent characteristic of bond and securities finance is the provision of better
risk-sharing than banks. When securities are spread across a large number of
individuals, the risk is more efficiently diversified. Better risk sharing then is an
incentive for creditors to commit themselves for longer periods of time, thus
facilitating the borrowers in meeting their long-term funding needs. Indeed, all this
adds up to the stability of the financial system.
Similar to the trend observed in most Asian countries, the major drivers of financial assets in
Pakistan are deposits and government bonds, whereas corporate bond issuances remain a
miniscule portion, with the total outstanding (listed) issues at Rs. 66.2 billion (0.5 percent of
GDP). Pakistan Investment Bonds (PIBs), introduced in the year 2000, remain the longest
tenor sovereign bonds, providing the benchmark yield curve for private issuances, whereas
National Savings Schemes (NSS), on the other hand, with tenors up to 10 years, provide
risk- free investment options to retail and institutional investors. The funds mobilized through
NSS reached Rs. 1.3 trillion by end April-09 (9.9 percent of GDP).
Historically, the key obstacle to the development of the corporate debt market has been the
competition for long term investment alternatives from the NSS instruments, which offer zero
risk yields higher than returns on corporate bonds. In order to align NSS rates with
marketbased yields on instruments of similar tenors, the yields on NSS instruments were first
reduced, and then pegged to the yields on the government's market-based long term bonds.
From March 2000, institutional investors were barred from incremental investment in NSS.
These measures helped in developing bond market to some extent as the number of
issuance increased subsequently. The corporate sector issued 69 TFCs worth Rs 45.7 billion
during FY01 to FY07. Market activity slowed down in the following years due to both overall
slowdown in economic activities and the policy-reversal by the government to re-allow
institutional investment in NSS. The corporate sector issued only two bonds worth Rs 6.1
billion during FY09.
In view of the above, the following factors could potentially facilitate the development of a
debt market in Pakistan.
(i) The banking sector, which has a virtual monopoly on providing financing to all
sectors of the economy, can play a central role in the development of the debt
market. Banks are often among the most important issuers, holders, dealers,
advisers, underwriters and guarantors in the market. Given the skewed nature of
their balance sheets with maturity mismatch issues, banks can issue long-term
bonds for Asset Liability Management (ALM). This is particularly relevant from the
perspective of financing long term projects. To further manage their risk profiles in
changing interest rate environments, there are now sophisticated risk- management
tools such as Interest Rate Swaps (IRS) at their disposal.
(ii) The central bank has a crucial role in promoting secondary market trading of debt
securities - by improving the effectiveness of monetary policy implementation.
Efforts to reduce the volatility of short-term interest rates, while credibly signaling the
policy stance, go a long way in increasing investor confidence while promoting the
maturity transformation of financial intermediaries' portfolios. Moreover, stable
money market rates foster repo activity and anchor the yield curve as trading
develops in longer maturities. SBP has focused essentially on improving the
transmission of the policy rate, by managing market liquidity and maintaining the
O/N repo rates close to the discount rate. This approach has proved to be very
effective and SBP will continue to work towards further improving the mechanisms
of monetary policy implementation.
(iii) Development of the term structure of interest rates depends on regular issues in the
primary market, increased trading activity in the secondary market, and providing
ease of entry and exit to both the issuers and the investors. Regular auctions of
Pakistan Investment Bonds (PIBs) since May 2006 is a step in this direction.
Developing bond markets and enhancing the capacity of public- and private-sector borrowers
to issue long-dated, domestic currency denominated debt securities is high on the country's
policy agenda. Among other factors, the presence of the requisite investor base is crucial for
the development of both the primary and the secondary markets in debt securities. The
regulatory environment should provide the right incentive framework to encourage both
individual and institutional investors to invest, and trade in, debt instruments. A wide range of
investors, with varying risk preferences, time horizons and trading motives would ensure
active trading and liquidity.
Having shared these thoughts, I would like to conclude by saying that SBP stands committed
to develop and diversify the financial sector in order to enhance its role in supporting
economic growth. Pakistan is standing at a juncture where investment in infrastructure is
crucially needed to facilitate the process of economic growth. The very nature of
infrastructure projects, where funding is required for long tenors and cash flows only start to
materialize after a certain time, is such that options for effective financing will only be
possible once there is requisite support from the development of the local currency bond
market and the financial sector provides access to a wide range of diversified financing
options.