The preceding few years have seen impressive financial and operating results from almost all the commercial banks in the country. Unmistakably, these across the board outstanding financial results are due to a range of comprehensive structural reforms that have occurred since April 1997 in the country's banking sector due to the combined, diligent and painstaking efforts of the Government of Pakistan, the State Bank of Pakistan and the international multilateral institutions.
These comprehensive reforms have been further augmented by the structural changes that have taken place within the financial sector in general and the domestic commercial banks in particular. It has taken a few years for the benefits to start making the impact and, presently, the domestic commercial banks are realising most of the then perceived benefits and rewards.
A closer examination of these financial results reveals that these extraordinary profits are primarily due to the high spread between the Lending and Deposit Rates.
As of August 2006, while the average Cost of Funds for the banking sector was in the range of 4%, the average Lending Rate was 14%. That is, the spread between the average Cost of Funds and average Lending Rates was well in excess of 9%. This high interest spread would be even higher in the case of Consumer Loans/Assets (admittedly to an extent commensurate with the credit and operational risks inherent in this type of lending) where the average Lending Rates were 20 to 28% giving a spread of 16 to 24%.
Prior to proceeding further, let me state, there is absolutely nothing wrong in generating impressive earnings and profits. Undoubtedly, profitable operations are inherently essential for any business operations as these very legitimate profits provide over the long term the critical resources either for expansion and/or new investments and, thereby, provide more job opportunities. However, these outstanding financial results for the past few years in the banking sector indicate that these profitability levels are probably at the expense of the ordinary depositor or saver.
This high interest spread, as stated above, becomes all the more striking as in deriving the KIBOR, there is an apparent built-in cushion. For the banking sector, collectively, the Average Cost of Funds in August 2006 was in the range of 4%. Adding all the other relevant cost factors that are applicable in deriving the KIBOR, the banks set the six months KIBOR rate at just over 91/2%. This 51/2% differential between the Average Cost of Funds and the six-month KIBOR does indicate, when compared with established international norms and practices, that there is a built-in cushion.
If all the other applicable factors in deriving the KIBOR are included this should cumulatively add not more than another 11/2 to 2%. This means that as of August 2006 a "cushion" of 3% approximately was also available. In other words, considering the minimal spread of 4% over the KIBOR that the banks presently charge, the Lending Rate comes to be 131/2%; and subtracting from this the more likely KIBOR rate of 61/2% means that the total spread is in excess of 9%. Thus, this set of calculations supports the one derived in the preceding paragraph.
The fact that the net interest spread has significantly increased is vividly indicated by the above graph.
The net interest spread between December 31st 2002 and 2004 has increased from 45% to 69%, respectively (in these two years period the interest spread has increased by over 50%). This has apparently arisen not from better liability management by the banks but from significantly lower returns to the depositors causing, thereby, a sharp decrease in interest expense in this comparative period.
Further, the above graph and the other one appended indicate that the commercial banks are generating an interest spread of 7.57% for themselves, while the average weighted return to the saving accounts holders is only 1.24% and the average weighted return on deposits is just 1.37%.
Thus, these extra-ordinary profitability results of the past few years are indeed solely at the expense of the depositors caused by the excessive/exorbitant interest spread. This, in turn, has apparently been derived by depriving the depositor/saver of an effective or a real return on his or her deposits and thereby also probably suppressing the country's saving rate.
This "excessive" spread is even more striking when the balances in the Saving Accounts are taken into consideration. Out of the total deposit base of Rs 2,355.7 billion, as of June 30th 2005, the savings account deposits were Rs 1, 264.1 billion. That is, 53.66% of the total deposits as of June 30th 2005 are in the category of savings account.
These saving account holders get a dismal return of 1.24%% as of June 30th 2005 while average weighted Lending Rate is 8.81%. Simultaneously, the overall spread has increased from 6.35% as of December 31st 2004 to 7.57% as of June 30th 2005. (See graph II)
Similar consolidated data for subsequent periods is presently not available, however, all indications are (based on the results declared by the banks during this intervening period) that this trend has been maintained if not further reinforced.
INFLATION AND INFLATIONARY EXPECTATIONS:
In his commencement address at Princeton University in May 2006, Ben Bernanke, the Chairman of the US Federal Reserve Bank, commented:
"In particular, low and stable inflation and inflation expectations enhance both economic growth and economic stability" and, more importantly, he further stated
"Stable prices are desirable in themselves. But stable prices are also prerequisite to the achievement of...other mandated objectives, high employment and moderate long-term interest rates"
Mr Bernanke in his semi-annual report on monetary policy to the US Senate Banking Committee in August 2006 said:
"Persistently higher inflation would erode the performance of the real economy and would be costly to reverse".
Undoubtedly, these pertinent comments only re-enforce the long and well established adage/maxim that controlling inflation and inflationary expectations are crucial for ensuring a sustainable, long term economic growth and prosperity in a country. These goals and objectives are equally, if not more, relevant to our environment as adherence to these goals and objectives would ensure that the country rapidly moves towards the achievement of the socio-economic goals of the Government.
Thus, beside the actual rate on a particular saving instrument, the above comments highlight the fact the other foremost factors that a saver has in his/her mind are the inflation rate and the perceived inflation rate.
It would be also pertinent to mention here at this point the relevant extract of the interview given to the Financial Times by Jeff Lacker, President of the Richmond Federal Reserve and part of the US Federal Reserve System (published in the Financial Times of November 8th 2006.
"The Federal Reserve has failed to communicate its determination to bring down inflation in a forceful enough fashion, raising the risk that price increases will become entrenched.
The reason inflation "seems to be so persistent...Is that we have not communicated very strongly that we want inflation to be lower and would be willing to take action to bring that about".
Needless to say these comments are as much applicable to Pakistan's economy as they are to the US economy. It would indeed be most desirable if our policy makers too continuously state and remind the nation of their unequivocal desire, commitment and resolve to bring the inflation down to lower level.
As and when the underlying inflationary pressures have resurfaced the State Bank of Pakistan (SBP) has taken steps, albeit somewhat delayed, to check these inflationary pressures. In an environment of increasing inflation rate over the past 18 to 24 months (commencing from the first quarter of 2005) SBP has played a critical role (to a large extent single handedly) in ensuring that the monetary policy and its implementation, results in controlling inflation (undoubtedly, the poor segment of the population in inflationary environment is the worst sufferer) and the inflationary expectations.
SBP's clear objective has been that the underlying inflation rate should remain within the acceptable parameters while, simultaneously, the efforts to have high economic growth are sustained so as to achieve the socio-economic objectives of the Government. The steps of increasing the Statutory Liquidity Requirement as well as enhancing the yield on T Bills were meant to hold back the excessive monetary growth and thereby reduce the inflation rate. However, further such corrective steps now appear more likely.
The inflation rate which had spurted to over 11.5% in the quarter ended March 31st 2005 has come down to less than 9% in the first two quarters of 2006. However, indicators for the third and fourth quarters of 2006 show that this downward trend has probably stalled at the level of 8%, thereby, now necessitating further tightening of the monetary policy.
Needless to say, the steps of the past few months are indeed commendable ones but need to be both sustained and reinforced to meet the country's objective of a lower inflation rate for the coming year, particularly if one takes into consideration that average inflation rate for Asia is only 2.5% (Source: "The Economist")
However, when timely action in curtailing both the inflation and inflationary expectations is not taken, the achievement of the socio-economic objectives, ie reduction in the poverty level, improving the per capita income, creating new jobs, giving a real return to the saving community, improve the overall quality of life for the citizens, providing/replacing the depleted infrastructure, etc can be adversely affected.
More importantly, the erosion of the performance of the real economy that sets in becomes difficult to reverse. Thus, no society or country can afford to neglect or have these long term socio economic objectives undermined just to meet the short term objectives.
In tandem with the tightening of monetary policy of the past 18 months plus, the commercial banks have also rapidly increased the lending rates. Thus, in line with this tightening of monetary policy, the 90 days T Bills rates went up from about 1.65% to over 91/2% within a period of 18 months. Simultaneously, in this similar period the average Lending Rates jumped from about 6% p.a. in the last quarter of 2004 to 14% in the second quarter of 2006.
These sharp increases in Lending Rates of over 8% (more or less in line with the increase in the rate for the T Bills, ie 8%) in 18 months period, of course, undermines the objective of having "moderate" long term interest rates - that are so crucial to having long term sustainable economic growth - and, more significantly, erodes the financial viability of any business venture or industrial project.
Any feasibility study can be undermined by having an unplanned or sharp acceleration in the financial cost of a project which in turn will affect the debt servicing capability of a project/venture and ultimately its viability. The fact that in the preceding two decades the Lending Rates have usually gone through abrupt and somewhat unpredictable increases has, most probably, adversely affected the investment climate in the country besides the ultimate viability of some of the new projects.
FINANCIAL INTERMEDIATION:
In playing the critical role of financial intermediation the banks undertake a range of risks (credit, market and operating risks) as well as extend a range of other financial services. Consequently, these products and services combine together to generate revenues which, after all the operating and other expenses have been absorbed, should give an adequate level of profitability commensurate with the risks along with generating adequate return to the shareholders. Further, this profitability then provides the basis of giving the necessary returns to all the stakeholders (which means the shareholders, the employees, the customers and of course the depositors).
Paradoxically the returns on savings deposits rates (excluding the hot money which moves wherever the best deposit rates are available and historically has not exceeded more than 10% of the total deposit base of the banking sector), the largest component in the banking sector's deposit base, have shown only marginal increase. That is, while the Average Lending Rates have increased by 153 basis points between December 31st 2004 and June 30th 2005, the rates for Saving Accounts have only moved up by only 91 basis points.
With average inflation rate of 8% during this period, and Average Weighted Savings Rate of 1.27% this translates into a negative return of 6% at least!
The real effective return to the saving account depositors is, however, even lower if the impact of the fine print, ie the "Terms and Conditions" for maintaining a savings account, is taken into consideration.
For example, the return is on the lowest balance amount in a specified period of every month and that too is only payable when other conditions are met such as maximum number of withdrawals per month is within the prescribed limit.
Further, the value of these return/profit is further diminished by the fact that while on the lending side the commercial banks charge the borrowing customer every quarter on the savings deposit the returns are given once every six months.
This factual position, admittedly, is indeed worrisome as these very depositors till now have provided over 50% of the resource base to the commercial banks and that too a stable one. The fact that the largest category of depositors, the saving accounts holder, continue to receive a rather dismal return of less than 11/2% could be due to the fact that the State Bank has not intervened to meet its other primary obligation ie to protect, safeguard and protect the interests of the depositors and the savings community.
As stated above, it is not the quantum of profits that the commercial banks are generating that is non-desirable or questionable; rather, it is the "excessive" and "exorbitant" spread. In addition to this spread of 6.5%, the apparent "3% cushion" in calculating the KIBOR is also added then the total spread is over 9%.
THIS "EXCESSIVE" SPREAD IS INDEED QUESTIONABLE AS THIS LEADS TO AN EARNINGS/PROFITS SITUATION WHICH APPARENTLY IS BEING DERIVED DUE:
-- to the anti competitive factors in the financial/banking sector, or
-- lack of market forces playing the necessary decisive role in a market driven economy, or
-- due to the apparent lack of improvement in the productivity factors, or significant improvement in the efficiency, or an overall improvement in the delivery of services.
Thereby, the end results - extraordinary profitability levels - are indeed questionable. Amongst other things, these extraordinary profitability levels indicate that the banks are totally geared towards the short term objectives and which, ultimately, could be detrimental to the country's economic interest.
The question then arises what is, in these particular set of circumstances, the role and responsibility of the Regulator?
THIS BECOMES EVEN MORE PERTINENT WHEN FOLLOWING FACTORS ARE ALSO TAKEN INTO THE EQUATION:
-- Are the Customers/Borrowers being charged far too much for the underlying risks undertaken?
-- Or are the interest spreads disproportionately high with respect to the quality and level of services rendered?
-- Or is it appropriate for the commercial banks to derive an apparently exorbitant/excessive spread?
-- Conversely are the benefits of the excessive spread, extraordinary profitability levels, only for the benefit of the shareholders and employees?
-- Further, is this sharp differential between the Lending and Deposit rates ethically or morally correct for the banks?
Needless to say, one of the primary responsibilities of the Regulator to a large extent is to safeguard, protect and defend the interests of the depositor. In this article an attempt is being made to analyse the factual situation, evaluate the impact of other critical factors on savings habit and the saving rates and then recommend some alternatives that may correct this anomaly. Once the reader has read this article, as well as similar other information, the reader should then be in a position to derive his/her own conclusions and thereby propose necessary corrective action steps.
(To be concluded)
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