Profitability of banking sector

For the last several years, most businesses have been hurting in Pakistan except the banking business with the profitability of the State Bank of Pakistan (SBP) and of the commercial banks (CBs) showing a sharply rising trend. The SBP is the central bank of the country, and a non-profit national institution, but it has realised record profits during the last several years.
Its profits amounted to Rs 181 billion in FY11 and Rs 261 billion in FY12. The CBs have also been showing rising profits year after year in the recent past. Their combined profits before taxation amounted to Rs 63 billion in calendar year 2008, Rs 81 billion in 2009, and Rs 115 billion in 2010.
The rising profitability of banks in an overall depressing business environment needs a critical review to avoid drawing misleading conclusions. On a deeper analysis, the rising profits of the SBP and of the CBs should ring alarm bells about fiscal mismanagement and financial disintermediation, rather than being perceived as representing sound performance of the CBs, the SBP and the government.
The main source of income of the SBP is return on its lending to the government and to commercial banks. In addition, return on its foreign exchange reserves, including capital gains on its gold holdings, and some income from the services it provides to the various sectors of the economy also contribute to the pool of its earnings. In the past, the SBP was just able to earn enough income to meet its expenditure and transfer small amounts of excess profits to the government after its nationalisation in 1974. However, in the recent years it has earned and transferred huge profits to the government.
Several factors have changed the character of the SBP from a central bank engaged in promoting monetary stability and financial discipline to a subsidiary of the government lending extensively to the government and contributing the largest amount of revenue after taxes to the exchequer.
First, the financial sector reforms of the 1990s mandated that government borrowing from the SBP should be at the market rates of interest as compared to the past practices when government used to pay only a nominal administrative fee or an arbitrarily determined low rate of return on borrowing from the SBP. From an economic point of view, these interest rate reforms were intended to explicitly bring on record the true cost of the government in the form of rising debt-servicing liabilities and thereby deter the government from excessive borrowing from the SBP. However, the government behaviour has been in just the opposite direction showing that prudence in fiscal management is the last thing it is concerned with.
The recent attempt to suppress the nominal rates by lowering the policy rate without halting government bank borrowing and substantially reducing the inflationary pressures may help the government lower its debt servicing cost. However, manipulation of the banking system and interest rates to finance fiscal deficit is very costly from the national point of view.
Second, in the past the government used to borrow relatively small amounts from the SBP because of its inflationary implications. The recent governments, particularly the current one, have indulged in massive borrowing from the SBP on a sustained basis, pushing the rate of inflation to double digits. It has unfortunately happened in a period in which the SBP enjoys statutory autonomy in determining and enforcing the limits on government borrowing from it on monetary policy considerations.
A large amount of government borrowing from the SBP at rising nominal interest rates has led to a substantial interest income of the SBP. Instead of taking pride in large interest income, the SBP and the government should really ponder over the adverse consequences of the expansionary fiscal and monetary policies.
Third, the government recently began to borrow at a large scale from the CBs as well, which in turn, used the discount window of the SBP for its own borrowings. This was a roundabout way of SBP lending to the government through the CBs but in the process collected interest from CBs rather than directly from the government.
The excessive CBs lending to the government financed by liquidity provided by the SBP has crowded out the private sector and interfered in their financial intermediation function. It has far-reaching adverse effects on inflation, private sector activity and indeed the entire economy.
Fourth, the revaluation of gold held by the SBP due to a rise in world gold prices gave a windfall profit to the SBP in the form of capital gains which it has transferred to the government. A reversal in international gold prices could have serious repercussions for the balance sheet of the SBP.
The rising profits of the SBP clearly represent the reckless direct and indirect borrowing of the government from the SBP at high nominal interest rates. Instead of collecting more tax revenue by modernisation of the tax structure, expansion of the tax base and improvement in tax collection, the government has adopted the easy course of printing notes through the SBP to finance its expenditure. Taxation through printing of notes is highly regressive in its incidence and it adversely affects saving, investment and growth as well.
If the SBP continues to earn high profits it would reflect financial indiscipline of the government. From an economic point of view, falling SBP profits would be an encouraging indicator of sound fiscal management by the government if it reflects a falling volume of government borrowing rather than financial suppression through a premature reduction in the policy rate.
The CBs' profits have been driven by three main factors. First, with a rise in nominal interest rates due to rising inflation, the CBs jacked up their lending rates without correspondingly increasing the rate of return on deposits, leading to a wider spread between rates of interest on deposits and on lending. This spread has remained excessive and the SBP has failed to convince/compel the CBs to bring it to the normal levels prevailing in other countries. Accordingly, the CBs have been reaping large profits at the cost of depositors and borrowers. It also suits the government which gets a share in the bounty in the form of corporate income tax.
Second, the banks have shifted their lending focus from the private sector to the government. For this purpose, they did not need to mobilise additional deposits as the SBP accommodated them through its discount window to meet their liquidity requirements. The banks have thus been able to make easy profits by lending to the government based on the liquidity provided by the SBP.
Third, and as a corollary of the second factor, the relative volume of loan defaults has declined releasing pressure on profits emanating from loan write-offs and restructuring. In the short run, it may seem to be a sound commercial banking policy but in the long run it will adversely affect the stability and viability of the banks. The risks of banks have increased enormously due to heavy exposure to a single party, even if it is the government. Moreover, the CBs have moved away from their main function of financial intermediation in pursuit of easy profits. The irony is that the SBP, instead of regulating the banking business to promote financial intermediation, is helping them to move away from it.
The rising profitability of the SBP and the CBs, largely reflecting increased government bank borrowing, should be a cause for concern for economic management team rather than a source of jubilance for the government, the SBP and the CBs.
The SBP, as the central bank of the country, should revert back to its core function of reserve money management to keep money supply within safe limits. In other words, it should reduce its profitability arising from large-scale government borrowing from it.
As regards CBs profits, right now they are earning 'rental income' due to ineffectiveness of the SBP in controlling both government bank borrowing and the interest spread of the CBs. The SBP should use its regulatory authority to reduce the interest rate spread and at the same time encourage them to mobilise more deposits at competitive rates and lend them to the private sector. The CBs' profitability based on an increase in the volume of lending to the private sector based on normal interest spread and improved deposit mobilisation would be a welcome development.