Shrinking banking spreads

It's a known fact that banks in Pakistan are not doing their supposed financial intermediation business of routing savings of large pool to lending businesses and consumers. In the developed world, big corporates and governments do not really rely on banks' lending. And banks justify their spreads by taking risk and lending to SMEs, commercial and small corporates. That is not happening here, still the spreads of banks (in the last decade or two) have remained the highest in the world.

There are a number of reasons for such an anomaly. One is that banks are overly regulated. In Khalid Mirza's words, banks in Pakistan cannot breathe without the regulator's permission. The other is that bankruptcy laws do not really exist. Recovery of bad loans is a pain. Judicial system tends to favour defaulters. There is a long history of willful defaults and political patronage in pre-privatization era (1970s-1990s).

After the financial deregulation and privatization, the banks gained efficiencies in operations and grew. The lending culture was slowly building but system weaknesses got exposed after the 2008 global financial crisis. Bad loans grew and peaked in 2011. To date, banks have only been able to recover a fraction of it. Thereafter, banks decided to become extra cautious in lending. A big bank's President lately said that we simply do not entertain new borrowers. How can entrepreneurship spur in such environment? Not to mention modern day Venture Capital firms are virtually non-existent, and traditional nonbanking lending institutions are nearing demise in Pakistan.

The new generation of bankers consists of lazy suited booted executives. Branches are shops to generate low cost deposits. Treasury desks are the bread earner. Higher spreads are hinged upon these two functions. Like whiskies, older the bank, smoother it is for the shareholders. Big five banks with over five decades of presence have better outreach of branches with sticky low-cost deposit base. Large pool of small deposits is in current account (at zero return) and saving accounts (PLS accounts). Life is not that easy for small banks who are relatively new in business.

On saving accounts (prior to 2008), there was no regulation of rates. The banks were offering too little despite the fact interest rates were high (2002-19 average at 11.7%). The cost of funds was low and banks were enjoying exuberant spreads. Banks were competitive in raising deposits and in brining efficiency in operations. Intermediation cost was reduced from 5 percent plus (prior to privatization) to 3-3.5 percent. But these efficiencies were only for shareholders' good, not much was shared with depositors.

One can sense that there were some prints of cartelization. Spread between return on risk free asset and saving deposits were 9-10 percent. Seeing that, SBP came up with the concept of minimum profit rates (MPR) on saving accounts (also known as PLS accounts) of conventional banks. MPR was initially fixed at 5 percent and the spreads were reduced to 6 percent. Over a period of time, SBP slowly and gradually started tightening the screws. MPR was linked to interest rates and the spread between MP was around 2 percent in Feb 20 with interest rates at 13.25 percent. The SBP shrunk the spreads further to 1.5 percent in Mar 20 and interest rates are down to 9 percent.

Some argue that there should be no MPR. There is none in most economies. In a competitive market, regulator should not set prices. But history suggests that banks in Pakistan do not give a fair share to the depositors. The consumer is small and large in numbers. Competition Commission is toothless. That is why SBP has to intervene. Interestingly, Islamic banks have no MPR (for technical reasons). The rates offered by Islamic banks are too low for saving accounts. If there is no MPR, chances are that saving rate for conventional banks will come back to its historic lows.

Nonetheless, there are some adverse implications of squeezing spreads. There is discrimination between Islamic and conventional banks. The latter is at a disadvantage. It is a double hit in days of pandemic and falling interest rates. Banks' profitability is usually on a decline in falling rates. The chances of loans getting toxic (bad) are higher in the days of lockdown. Banking profitability will take a dip. Banks made pre-tax profits of Rs304 billion in 2019. The lower spread will reduce banks pre-tax profits by Rs20-25 billion. Lower interest rates will cause more dent on profitability. Time is not far off when banks start laying off workforce.

Smaller banks are at higher risk. The cost of fund is higher for smaller banks. Overall spreads are thin for them. The rerun on equity is becoming too low for smaller banks, they might start merging into big. Non-banking finance companies (NBFC) are already on death knell. Without specialized lending institutions and niche banks, it's hard to expand financing reach. This is not good for mutual fund industry as high rates on saving accounts will make money market funds less attractive.

The flipside of lower spreads is that it will push banks to lend to SMEs, consumers and agriculture. Since the spread is shrinking, some banks may have negative spread (over cost of fund) for lending to big groups and government. Banks will strive hard to reduce intermediation cost by investing in technology.

All these good consequences are for the medium to long term. There is more pain for banks in the short term. Banks are frontline brigades for a central bank to keep businesses afloat in unprecedented days. Timings of these squeezing spreads are not optimal. Banks need some cushion to lend to those who are in need in the short term. The SBP might need to give them some breathing space in such days. And focus on depositors' return protection later. One suggestion is to do away with super tax (especially for small banks). The other is to reduce the spread shrinkage by 25 bps or link the incentive for banks on lending to SME, mortgage and Agri.