Commercial banks have released their 2005 operating results. For bank owners and managers it is time to rejoice because growth in profits and returns on equity is breathtaking.
Banks anywhere would be amazed at the results achieved by Pakistan’s large domestic banks, and a couple of foreign banks that expanded their networks in spite of the horrible picture of Pakistan the foreign press paints, almost everyday.
Several banks managed to achieve between 50 to 75 per cent growth in their pre-tax profit over 2004 without a commensurate (in fact a much lower) rise in their earning assets.
No less amazing is the fact that 2004 itself was a record year (till then) in the context of profitability growth. The handful that performed badly, were handicapped by basic structural problems, or in their formative stages. They may be targets for takeover bids, would be the new market trend. Given this backdrop, what we are witnessing is indeed remarkable.
The profit growth cycle that began in the second half of 2002, is nearing the end of its fourth consecutive year. It is an enviable success story for banks in a country that remains entangled in problems that frequently de-stabilize its financial sector. This profile of the banking (comprising nearly three dozen banks) conveys the impression that the sector is moving in the right direction, and the growth cycle continue. But the question that haunts many minds is “will 2006 see a new peak or …….?”
First, a close examination of the sources of income suggests that profits declared by many banks include uncomfortably large chunks of revenues generated from trading in equities. The worry about sustaining this source of revenue is rooted in the fact that Pakistan’s bourses don’t have a reputation for rational behaviour. Given the unchallengeable power of the stock-broking community, improved regulation of the bourses is not in sight, which renders this bulky profit component undependable.
Second, when compared with the rise recorded in earning assets, the rise in gross mark-up income seems disproportionately high. The high spreads over deposit cost being earned by banks suggest that while banks are benefiting from high lending rates, these benefits are not being shared with depositors. This distortion is giving rise to customer dissent.
How long can banks go on charging high mark-up rates to their borrowers, and pay depositors the lowest-ever rates of return, places in doubt the sustainability of this income.
Third, rise in consumer lending, though a welcome development, has been excessive given the fact that institutional arrangements (risk-relevant consumer databases and credit referencing agencies) are not fully geared up for supporting consumer lending on reasonably secure bases. To make things riskier, Pakistan’s legal system isn’t as robust as it should be, to protect banks’ interests and settle recovery suits fast enough.
Fourth, non-mark-up income (service charges) conveys a worrisome rise because it is disproportionately high compared to the rise in bank assets and liabilities and is also out of line with the trend in core inflation.
In some banks it rose 100 percent over its 2004 level. That’s not all, the quantum of many new service charges lack requisite justification. Seen in this backdrop, rise of bank profitability is mystifying because it lacks the logic that can assure its continuity.
To the overly suspicious, these weaknesses provide the logic to view rising bank profitability as the outcome of self-serving behaviour on the part of bank owners and managers. They believe that banks are no longer serving as the ‘efficient’ intermediary between savers and investors because depositors as well as borrowers are unhappy with banks’ pricing mechanism – lacking in realism with which banks have been recovering their intermediation fees.
There is more than a grain of truth in this argument because in developing countries the interest rate spread ranges between 3 to 4.5 per cent. According to SBP’s most recent statistics, the spread being earned by Pakistan’s commercial banks as a whole is almost 7.25 per cent, which places in doubt the loud claim about banking sector’s efficiency.
The people now heading the big banks had earlier held senior managerial positions in foreign banks, and the expectation was that intermediation costs will go down. That expectation wasn’t met while five long years went by. Instead, bank profitability surged while efficiency continued to lag behind. Profits therefore don’t reflect the result of fairly priced services.
Based even on the questionable official estimates of inflation, depositors are earning huge negative real rates of return. Frustrated depositors are therefore opting for investing in speculative businesses about which most of them know nothing. An indication thereof is the rise of mutual funds (many floated by banks) to cater to such investors but the flip side of this coin is that savings are gradually leaving the banking sector.
Loud notes of dissent over these trends are now audible. In some circles, regulators are being blamed for inactivity. It may be an over-reaction but it is an historic reality that regulatory inactivity nourishes resentment against free markets if inequalities keep spreading. Suspect nature of official economic indicators and glib-talking skills of the defenders of status quo can’t negate this reality.
In de-regulated markets, Central Banks tend to worry more about being blamed for intervention than about developing economic distortions. That is a grave miscalculation. Britain too is a free market but reacting to the distortions created by escalating bank charges, recently the Office of Fair Trading issued a stern a warning to banks to cut their charges or face litigation.
Until a similar authority is created (which is overdue), regulators in Pakistan are under an obligation to ensure that the system fairly balances the interests of all stakeholders.
Urgent regulatory action is necessitated by two other developments: the pressure for injecting Rs1 billion to the capital every year until 2009 (which bank owners would want funded almost entirely by capitalizing future earnings) and accelerated (one year instead of two years) loan loss provisioning, would encourage banks to earn even higher profits. Given their recent track record, banks could become more self-serving in pricing their services. Alternatively, they could merge to comply with these pressures.
The belief that large banks tend to be stronger is a half-truth that central banks now bet on overlooking the fact that failure risk can’t be minimized by merely enlarging the size. In developing countries, bigger banks run higher risk of mismanagement and of coming under stress. These risks are compounded if there is a serious shortage of skilled workforce to manage large banks in prematurely deregulated markets that also permit selling high-risk products and services.
Pakistan is one such market and the future poses more questions than beckon its bankers to indulge in more of what they have been doing. It is time to accept the reality that, to be sustainable, profit growth must rely essentially on internally generated efficiency, not on questionable pricing practices.
