Deconstructing private sector lending

Reasons why Pakistani banks don’t lend to the private sector—and tend to be more averse to some segments such as home loans, and SME finance than others—are well-established through a mountain of growing research across the globe (and in Pakistan).

While overall private sector lending is low, lending to SMEs is even lower and most of all, hasn’t changed. Advances to corporate sector as a share of total private sector lending are currently about 72 percent of total while SMEs have 4-5 percent share (that has also not changed). As a share of private sector business loans, the same between SMEs and non-SMEs is 9 percent and 91 percent respectively which hasn’t changed at least as far back as 2015. Meanwhile, the infection rate for the former has always been lower—8.9 percent last year in Dec-19 growing to 10 percent in Sep-20 against the higher 16 percent and 21 percent for respective months in the case of SMEs.

Demonstrably, banks want it easy (government securities are easy and safe even at a low-price) and they want to make sure borrowers will pay them back. There are some obvious and predominant factors that make lending to private sector difficult, especially SMEs. Banks require immovable and titled collateral which can be seized in case of default (SMEs typically don’t have property assets and only carry movable assets such as receivables, inventory, produce, vehicles). They have great difficulty in credit assessment for SME businesses due to information asymmetries (limited credit history, SMEs lack capability to keep proper financial records), which leads to adverse selection (riskier assets are more likely to seek loans compared to less riskier assets) and to avoid which banks stay away from SMEs entirely. Lending administrative costs also tend to be higher for smaller firms as information gathering requires more resources as a percentage of the underlying loan, which is typically small.

As a result, banks’ decision to lend often depend on firm size, collateral and banking connections and prior relationships. That’s supply-side. Demand-side issues are entirely different.

Now a number of interventions are taking place that should lead to growth in private sector lending. Secured Transaction Act 2016 has led to a creation of a registry that would record charges created by firms on their movable assets which would enable banks to use these assets as collateral. The SBP has granted licenses to two private sector bureaus, Data Check and AISL, to set up shop and provide credit information for borrowers to financial institutions. There is huge scope for building financial and non-financial information database which can help FIs to evaluate credit worthiness (granted vigorous data privacy and security laws are in place).

Creditor rights are also crucial. Banks have historically been hesitant to dole out mortgages in the absence of foreclosure laws which authorize banks to foreclose on properties of defaulted borrowers without recourse to the courts. After multiple back and forth spanning several years, the decision to uphold these laws with some amendments has been made which should ideally make banks feel safer with housing finance.

And apparently, they will have to, as the SBP in light of the Naya Pakistan Housing Program has instructed banks to maintain mandatory 5 percent home loans in their total private sector lending—which currently stands at 1.4 percent. So far, there is no movement in home loans to suggest any changes due to policy.

The same is the case for SMEs. Despite a dedicated policy to route lending toward SMEs, a credit guarantee scheme that had nominal success and the most recent SME concessional support; not much has changed. The National Financial Inclusion Strategy launched in 2015 remains persistently behind its set lending targets in finclusion. Perhaps, the only scheme that has worked is the export finance scheme which has demonstrated growth—both proportionally and in value terms (that it led to substantial exports is questionable and outside the scope of this discussion).

Evidently, whether the conventional model will work with the aforementioned (and much-needed) regulatory and institutional interventions is a question of both if and when. There is definitely a demand-supply gap in specific important segments that commercial banks are not too motivated to meet and may never be—despite government’s lending targets. The space it seems is wide open for fintech and digital innovators and non-banking segments to rise to the challenge—which is happening across the world. Will they? More on that later.