Over the past few years, the banking industry has emerged as one of the better performing sectors of the economy. Be it after-tax earnings growth, dividend yields or stock price appreciation, most variables have hit their mark, enriching executives and stockholders alike in the process.

However, one important variable that has taken a bit of dip lately is asset quality. And within this category, two sub-variables stand out: capital issues and non-performing loans (NPLs).

After reaching Rs618bn in CY12, the industry’s NPLs had shrunk to Rs602bn by end-March 2014. But over the next year, they started to grow, ultimately reaching Rs620bn by this March.

Similarly, in the most recent memorandum of economic and financial policies (MEFP) submitted to the IMF, the government admitted that “as of end-March, [the banking sector’s] asset quality has slightly deteriorated with an increase in the NPL ratio to 12.8pc, and the net NPLs to net loans ratio rising to 2.8pc”.

But sector analysts have attributed the growth in NPLs mainly to individual corporate defaults, including one by a major refinery complex, rather than any general worsening in the health of the overall corporate sector.

And while a clearer picture will emerge when banks start releasing their half-yearly results over the next few weeks, based on first quarter data, the concern over rising banks’ NPLs and risk-adjusted capital levels seems to be limited to individual entities rather than the industry as a whole.

Lending: The development on the NPL front is surprising given the anaemic growth in private-sector lending by banks during the last fiscal year, but for the sluggish growth in some segments of the economy.

“Banks have continued to display a risk-averse stance despite the substantial cut in interest rates. Private-sector credit growth remained muted during 5MCY15. While loans to the agriculture and utility sectors have been encouraging, manufacturing, construction, real estate, commerce and trade loans fell during the period. Consumer financing, on the other hand, grew by 4pc, with the growth largely coming in the automobile financing space,” wrote Elixir Securities analyst Ujala Adnan in a recent research note.

Unlike the recent bad debt problems that appear to have mostly affected large and mid-tier banks, the capital issues are almost entirely limited to some small banks

Meanwhile, Kasb Securities banking analyst Farid Aliani pointed out that the rise in the industry’s NPLs was almost entirely due to the abnormal Rs10bn growth in the state-run National Bank’s bad debts in the first quarter.

While he admitted that NPLs had gone up last year as well due to the default by the oil refinery, the affected banks had already classified those loans and have been booking provisions against them since then.

Capital issues: In implementing the Basel III accord, the SBP has been periodically raising the capital requirements for banks. This has been a particular worry for smaller banks, who don’t have the kind of access to deep-pocketed sponsors or name recognition that the bigger banks do.

After repeatedly extending the deadline for banks to meet the net minimum capital requirement (MCR) of Rs10bn and the capital adequacy ratio (CAR) of 10pc, the SBP had set the final deadline for end-2014. However, at least four banks were non-compliant with one condition or the other by end-March.

And unlike the recent bad debt issues that appear to have mostly affected large and mid-tier banks, the capital issues are almost entirely limited to small banks.

According to the MEFP document, “only one bank (out of 36 banks) remains CAR-non-compliant. The size of this bank is about 0.85pc of banking system assets (or 0.4pc of GDP). The bank’s CAR is at 9.36pc (against the 10pc requirement) and it is expected to complete a rights issue by June, which will enable it to become CAR-compliant. Four small banks, while remaining CAR-compliant, are still below the MCR”.

But the government added that the industry’s “CAR has increased to 17.4pc. [And] we have devised a time-bound plan to bring these banks into regulatory compliance”.

One of these is the First Women Bank Ltd, in which the government has a 72pc stake. The bank says it has been allowed by the SBP to meet a reduced MCR of Rs3bn and a higher CAR of 18pc. But by end-March, its capital stood at Rs2.49bn.

“After the action on [a troubled small bank], all [other private] banks not meeting both the MCR and CAR requirements immediately announced a rights issue to bring their paid-up capital (net of losses) to Rs10bn, thus resolving the MCR issue. Other smaller banks that continue to have lower MCRs have been especially asked by the SBP to maintain enhanced CAR levels (higher than the generally mandated 10pc) to compensate for their lower paid-up capital, until such time that they meet the MCR of Rs10bn,” said Aliani.

“Generally, all the banks are likely to be fully compliant with these requirements within FY16. Thus, the system is generally healthy and stable,” he concluded.

“This definitely is not a systemic issue, as the IMF itself admits that these banks form only a small share of the industry. Besides, there are very few options for small banks in general to raise fresh capital; mostly its either an equity injection by their sponsors or a rights share issue. And one of these four banks is already in the process of issuing rights shares to boost its MCR, while the other has just completed acquiring a troubled bank,” noted Zeeshan Afzal, head of research at Taurus Securities.

When asked for his opinion on whether the IMF will continue to pressurise the government to get these banks into compliant territory, Afzal said it is unlikely, mainly owing to the almost negligible risk they pose to the industry.

Published in Dawn, Economic & Business ,July 13th, 2015

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