In view of the global banking crisis and the economic conditions, concerns are also expressed for the health of domestic banking system. Apart from very little exposure to the developed financial markets, local banks largely focus on conventional lending and are immune from the current global fiscal turmoil.

While the crisis has been there for sometime, the central bank governor found it necessary to reassure the business about the resilience and soundness of the banking system. This has been spurred mainly by the domestic reasons and especially the recent huge withdrawals of money from the banks and abnormal raise in overnight inter-bank interest rates.

One reason of the large withdrawals is understandable. It is a normal pattern in Ramadan and Eid season for the people to withdraw their money from banks for zakat, charity and Eid shopping etc. According to one estimate, the Eid shopping generated Rs70 billion business this year. However, in past such withdrawals had been treated as normal and had not created any alarm as it has done at present.

The reasons for this situation are also obvious. At present due to the tight monetary policy and no fresh capital inflows in due to the security concerns, banking system is facing the liquidity shortage. Not only most of the ATMs remained in-operative during the Eid days but the customers also faced difficulties in obtaining cash from banks before the Eid holidays.

The other cause for concern is the country’s economic situation especially the depreciating value of rupee. This gave rise to rumours about freezing of FC deposits etc. In some cases, such rumours play an important part in bringing out the collapse of the banking system irrespective of its technical and financial soundness. The past experience of freezing of foreign exchange deposits also lent some credence to such rumours.

The trust is the basic ingredient in the functioning of banking system and the loss of confidence may trigger a collapse of an institution or the system itself. The rush of the depositors for withdrawal of their money is one of the symptoms of such loss of trust. It is the core function of the central bank to maintain the trust of the system by protecting the interests of depositors. That is why the central bank intervened promptly. It has not only reduced the Cash Reserve Requirement by two per cent in two phases to improve the liquidity position of banks but has also injected more dollars in the market to stabilise the rupee.

The solvency of the banking system has remained a priority for the central bank for which it has not only taken various steps time and again but has rescued banks on the verge of insolvency. In the recent past, various steps were taken such to help banks reducetheir non-performing loans (NPLs), increase their capital base and promote good governance and best practices etc.

Today, the banking scene is entirely different from 1980s and 1990s when some of the major banks were on the verge of insolvency. In 2001 the capital to risk weighted assets ratio of the banks was amongst the lowest in the region which has now increased sharply to 13 per cent.

In fact, this ratio also includes, for the first time, Rs446.5 billion for the operational risk charge in compliance with the implementation of Basel II. The domestic banking institutions are adequately capitalised. More important, the increase in this ratio over the last five years came along with a robust credit growth. The banks achieved this higher ratio by raising capital instead of reducing risk weighted assets.

While still on sound footing, banks future remains uncertain. After enjoying a period of boom, high incomes, low defaults and surplus liquidity for some years, the banks have now entered a new phase and face some difficult problems. This is due to large amount of advances given without looking at the credentials and repayment capacity of the customers, the slowing economic growth and inflation.

The profits of the banks have declined and the return on the equity and assets has shrunk in the quarter January-March 2008. This is also due to fact that although the rate of return on the banks’ loans has increased but the overall spread has declined due to the rise in the deposit rates. Latest reports indicate that the spread increasing once gain.

The non-performing loans (NPLs) aare showing an upward trend since 2006. Loan defaults are not abnormal for banks, being an integral part of the banking business. But it is worrisome when huge defaults become unmanageable.

Although this trend in default is more evident in the consumer loans, it is not limited to one or the other sector. Over time the overall loan portfolio is getting more infected, especially the increase in NPL to loan ratio of the corporate sector--the largest borrower.

This ratio increased from 6.7 in March 2007 to 7.8 per cent in March 2008. This sector complains against the tight monetary policy and increase in the interest rates. Given the overall economic conditions, an increase in the loan default ratio of this sector may not be ruled out.

The infected ratio of the loans rose from 5.7 in CY2007 to 6.8 per cent in January-March, 2008 which is still considered to be manageable. In absolute terms the amount of NPLs rose by Rs18 billion to Rs32 billion in January-Mar 2008 whereas the net NPLs increased by Rs6 billion in the same quarter.

While the situation is still not alarming, the key ratios are creeping up as the total NPL to loan has increased from 7.4 to 7.7 per cent and net NPLs to loans from 0.3 to 1.7 per cent during the quarter January-March 2008. Similarly, NPL coverage ratio declined from 86 to 84 per cent in the same period. The banking system stays above the satisfactory level but increasing NPLs present caveats for it.

In today’s world both internal and external factors affect the financial markets and especially the banking system and need constant supervision on the part of monetary authorities.

Recently, the banks have been given a time frame for enhancing their paid- up capital gradually to Rs23 billion by December 2013. Apart from strengthening the capital base of the banks, one effect of this measure would be the consolidation of the system as those which would not meet the requirement may chose merger with other major and sound banks or to close down.

The banking system is on sound footing. But no banking system functions in isolation and the economic, political and psychological factors play direct and indirect role in determining its solvency. Therefore, a constant surveillance is imperative.