Financial sector has shown strong resilience: SBP

Pakistan's financial sector has shown strong resilience to a challenging macroeconomic environment and global developments, says State Bank's Financial Stability Review 2008-09, released here on Wednesday. According to the Report, Pakistan's economy had suffered from stresses of its own in addition to the second-round impact of the crisis transmitted through the trade channel and the reversal of capital flows.
Notably, the implementation of the macroeconomic stabilisation program with the support of the IMF SBA since November 2008 has facilitated the process of economic recovery, though at a quite gradual pace at this stage, it added. The report said that CPI inflation had declined to 8.9 percent in October 2009 since touching its peak of 25.3 percent in August 2008.
The current account deficit narrowed to $540 million in Q1-FY10 as compared to $4,258 million in the same period of last year. The performance of the fiscal and the real sectors, however, remained tenuous, as did the flow of credit to the private sector.
With the improvement in some macroeconomic indicators and the upgrading of the country's sovereign ratings by Moody's and S&P's, portfolio flows had resumed, with positive cumulative net flows of USD 314.0 million recorded from July FY10 until mid-November FY10. As a result of all these developments, SBP's foreign exchange reserves increased to $10.4 billion by mid-November FY10, the report said.
According to the report, the size of the country's financial sector, which includes banks, non-bank financial institutions (NBFIs), microfinance banks, Central Depository of National Savings (CDNS), the insurance sector, and financial markets, in terms of assets increased to Rs 8.2 trillion by end-June 2009 from Rs 7.1 trillion at the end of December 2007. The report summarises the developments over 2008 and the first of half of 2009.
The report says that the stability of the financial system largely derived from the predominant position of the banking sector, as other components of the financial system continued to grow at a more gradual pace.
As opposed to the speculative tilt in conducting the business of banking in western economies, the underlying operating model of the banking sector in Pakistan fulfils the basic requirements of the function of financial intermediation: loans and advances are funded by a large and growing base of deposits, with virtually negligible reliance on borrowing, or the short-term wholesale market for financing assets.
The report noted that growth in deposits did slowdown to 9.4 percent in CY08 after growing successively at an average rate of 18.1 percent for the last 5 years, despite the increase of 17.2 percent (in USD terms) in home remittances; a reflection of both the slowdown in the economy, preference for hard currency due to the prevalent environment of uncertainty, and competition from the National Savings Schemes (NSS) offering a higher rate of return than bank deposits.
"These developments even overshadowed the potentially positive impact of introducing the minimum rate of return of 5.0 percent on all profit and loss (PLS) savings deposits by the SBP, w.e.f. June CY08," it said and added a visible increase in the currency to deposit ratio and a slowdown in the money multiplier during H2-CY08 also highlights the challenging operating environment of the banking sector.
Notwithstanding, deposits growth picked up pace in H1-CY09, growing by 8.2 percent in H1-CY09 alone. But the impending transfer of government deposits from banks to a single treasury account maintained by the State Bank of Pakistan can potentially have a significant impact on those banks which have a large reliance on these deposits, it said.
The report said that banks' exposure to the government increased tremendously during CY08, with particular concentration in the power sector due to the issue of circular debt and unprecedented increase in lending to public sector enterprises (PSEs) and commodity finance in general.
It said that heightened concerns on credit risk surfaced in Q1-CY08, and became pervasive as the year progressed as non-performing loans (NPLs) rose by 68.4 percent in CY08 to Rs 359.3 billion by the end of the year-the biggest increase in a single year since CY97.
"While aggressive credit expansion in the last few years played its role in this visible deterioration of asset quality, the widespread rise in NPLs is seen to be a direct consequence of macroeconomic instability, and largely a cyclical rather than structural factor," it said, and added that "this assertion is supported by the slowdown in the growth of incremental NPLs in the first half of CY09 to Rs 397.9 billion, as the process of economic recovery picks up pace".
The report noted that encouragingly banks' ability to absorb unexpected losses was on a strong footing. Implementation of the minimum capital requirements in a phased manner continued to strengthen the capital base and the aggregate risk-weighted capital adequacy of the banking sector as of end-CY08 was maintained at the CY07 level of 12.3 percent against the minimum requirement of 9.0 percent, despite the inclusion of the capital charge for operational risk under Basel II requirements.
"This is also due to the anti-cyclical policy support extended by SBP in response to the difficult operating environment, as reflected in the rationalisation of the MCR requirements, with a subsequent enhanced concession in the FSV rules in October CY09," it said.
The report pointed out that while Pakistan's financial sector was not directly impacted by the events in the global financial markets, various developments over the period of assessment did alter the risk profile and outlook of the financial sector.
These developments included: (i) banks faced a temporary liquidity strain in Q4-2008 which translated into solvency problems for some of the weak small banks, (ii) the liquidity stress brought forth NBFIs' dependence on the banking sector more visibly as their credit lines from banks dried up, (iii) rising NPLs, monetary tightening and structural impediments in the economy hampered the flow of credit to the private sector, (iv) deposits growth slowed down, (v) banks' exposure to the public sector increased substantially, and (v) the equity market's capitalisation declined by around 63 percent (from its peak level) by end-CY08 while the exchange rate depreciated by over 20.0 percent against the US dollar.
Referring to other components of the financial sector, SBP's report said that the dormant element of funding risk in case of non-bank financial institutions (NBFIs) emerged as a strong threat to their commercial viability in CY08. NBFIs are largely dependent on banks to fund their assets, and in the wake of the liquidity strains faced by the banking sector in Q4-CY08, these credit lines dried up to the extent that the viability of their ongoing operations came under threat.
"Notably, NBFIs have long lost their niche in the face of competition from the banking sector, and the leasing companies, investment finance companies, modarabas, venture capital companies seriously need to rethink their business model if they are to remain commercially viable," it said.
Similarly, it pointed out that insurance sector continued on its sluggish pace of growth and gradually increasing penetration of insurance services. The insurance industry enjoyed robust growth in the last few years, driven by favourable economic conditions, expansion of the financial sector as a whole, privatisation of large state-owned entities and foreign investments.
But factors such as the emergence of macroeconomic instability since late 2007, turmoil in global financial markets and dislocation of the domestic equity market along with the deteriorating security situation has posed substantial challenges to the performance of the insurance sector in CY08, it added.
The report asserted that an efficient financial system is one which is diversified, and in which all components function in meeting the financing needs of the economy. "Not only does Pakistan's economy continue to have an undue reliance on the banking sector, the emergence of the government as the major user of bank credit has led to the crowding out of the private sector even as the economy is headed towards a gradual recovery," it added.