Mark-up spreads

Last week, the Governor State Bank of Pakistan (SBP) addressed the presidents and senior executives of commercial banks and DFIs on a variety of policy, administrative, and operational issues that require greater focus of the banks. Such reminders are necessary to ensure that financial services don't digress from the objectives being pursued by the state.
While he rightly emphasised the need for resource mobilisation, higher lending to the private sector, improving service standards by reducing complexities therein, containing frauds, increased IT security and storage of back-up data, rationalising frontline employees' remuneration, and their purpose-oriented training, his warning about forced lowering of mark-up spreads is debateable.
Indeed, mark-up spreads must not cross the limits of rationality because banks act as intermediaries between savers and investors and therefore shouldn't aspire to earn returns on equity higher than those earned by their borrowers, but mark-up spreads also include components representing a mix of unsecurable risks that lending institutions confront in country-specific environments.
In countries blessed with environments wherein most risks are fairly accurately measurable because of effective regulatory set-ups and dependable public security and most risks are insurable, mark-up spread (except on consumer lending) can be as low as 3.5 percent. Low cost of funding afforded by such a spread significantly improves competitiveness of businesses.
An equally important contributor in keeping mark-up spreads low (due low loan losses) is the capacity and commitment of the financial institutions to prudent risk management, and the key element therein is the ability to monitor the use of borrowed funds in venues agreed with the lending institutions based whereon the borrowers' risk is assessed.
The SBP Governor's desire to bring the overall mark-up spread down to 4.5 percent assumes that the lending environment in Pakistan is nearly as secure as described above. However, realistically speaking, this is an overoptimistic view of Pakistan's security and regulatory environment. Pakistan's current sovereign and country-risk ratings portray a less attractive scenario.
Even if you set aside for a moment the risks businesses and financial institutions confront due to security issues, the risks arising out of weak regulation of the financial sector's support services, inadequacy of insurance cover-types and the hedging contracts are enough to justify high mark-up spreads on the ground that the cost of these risks is eventually borne by the lending institutions.
Risks arising out of incorrect valuation of assets (financed or held as collateral), insecure custody of financed goods, and frauds in domestic transportation of goods, have together saddled financial institutions with huge losses. In spite of growing incidents of losses arising out of weak or near-absent regulation of these services, we saw no corrective actions being taken either by the regulators or the financial services sector.
The bases whereon asset valuation agencies are issued licences to operate are outdated; what is needed is a revamp of the standards in this context along the lines adopted by the better regulated economies. That this exercise is overdue has been pointed out by several stakeholders, who also provided the regulators the details of the changes implemented in other countries.
Rarely were asset valuation agencies punished for instances of overvaluation of assets although renewal of their licences only after annual review of their performance is imperative. Such performance review is also necessary for exposing possible connivance between asset valuation agencies, borrowers and bankers, if corrupt lending practices are to be checked.
The rise of independent goods custodial services owes itself to the culture of 'outsourcing'. No wonder it has been a major cause of loan losses courtesy disappearance of financed goods while in custody of independent custodial service agencies. Despite this outcome, this critical service remains largely un-regulated. There are no clearly-defined rules of conduct for these agencies.
There are hardly any standards whereon to assess the capability of warehouse custodial agencies' security staff for stacking of goods per goods-specific requirements, monitoring the maintenance of goods-specific light, temperature and humidity in the warehouses, preventing goods' corrosion, inflow/outflow-based updating of stock cards, and responding to emergencies like fire and dacoity attempts.
There was a time when, within Pakistan, almost 75 percent of the cargo was transported by Pakistan Railways (PR). It was a secure mode of transport. Now just 17 percent of cargo is transported by PR because, over the years, this key institution was systematically destroyed to promote the trucking sector, which is now massive, and yet almost entirely unregulated.
An example thereof is that today, when a huge quantity of goods are bought/sold under inland Letters of Credit and therefore require documentary evidence of transport of goods on a standard format (equivalent of an ocean Bill of Lading), a standard format of this document is yet to be devised and enforced on all trucking agencies; each agency uses its own format.
This scenario, that went unnoticed for decades, reflects on the attitude of the financial institutions and the regulators. Instead of demanding stiff terms for pre-qualification and licensing of these services, and regulation and monitoring of their performance thereafter to limit losses caused by their malpractices, financial institutions have opted to recover such losses by hiking up mark-up spreads.
Bank lending during the last decade, and the turmoil it caused beginning 2008, shows that besides less than prudent lending, the area wherein a slide has been visible is lending institutions' risk monitoring abilities due to over-reliance on outsourcing some segments of this vital function. What has compounded its harmful effects is the downgrading of bankers' training in this area.
Instead of upgrading their risk monitoring abilities and capacities, banks' risk-aversion (in lending to the private sector) has triggered excessive sovereign lending. It is a well known fact that, in Pakistan, a rupee generates far less value in terms of real return when borrowed by the state, compared to the private sector. Not surprisingly therefore, GDP growth has continuously contracted in the last six years.
Without commenting on the current global perception of Pakistan's sovereign risk, and instances wherein claims under sovereign guarantees were not honoured, the tendency for excessive lending to the state needs shunning. But to encourage such a trend, the variety of unmanageable risks posed by insecurity and unregulated support services must be mitigated.
If regulation of these services remains as weak as it is and internal security as uncertain, asking banks to reduce their mark-up spreads would be unfair; doing so could force some to wind up and others to lend only to low-risk entities, whose worst sufferers will be the vital SME sector - neither is a good outcome for Pakistan's contracting economy, given investors' waning confidence, and low domestic resource mobilisation.
Finally, many loans go sour despite borrowers' sincerity because appropriate hedging tools for covering mark-up and exchange risks aren't traded in Pakistan's financial markets. Often, even the available hedges can't be bought because banks are unable to offer over-the-counter contracts (ie in non-marketable lots). Developing this market to fulfil these needs requires SBP's urgent attention.