Stability of Banking System

4STABILITYOFTHEBANKINGSYSTEM
4.1Introduction There is widespread agreement on the fact that the earlier than expected recovery of the global economy is a prelude to improvements in both consumer as well as producer confidence; however the process remains uneven and patchy leaving some countries, sectors, industries, and at the micro level, some firms, still struggling to breakeven. In Pakistan, the indirect impact of the Global Financial Crisis (GFC) and ensuing recession in advancedeconomieswasclearlyevidentin2009.AsintherestofAsia,theindirectimpactof the GFC manifested itself in various forms in the real sector of the economy. However, the majorchallengesfacingthedomesticeconomyduringtheyearcanonlybepartlyattributed totheGFCitself.Indeedtherewasadeclineinexportsduetorecessionineconomieswhich are Pakistans major trading partners, and there was pressure on capital flows1 where strainedliquiditypositioninglobalfinancialmarketsimpactedforeignportfolioinvestment. However,factorssuchastheenergycrisisleadingtounderutilizationofindustrialcapacity and rise in the cost of production, the longstanding issue of intercorporate circular debt, considerabledeclineinforeigndirectinvestmentduetoweakeconomicfundamentals,and above all, the mounting fiscal deficit breaching previous records in the countrys economic history, all had a role to play in keeping the process of economic recovery in Pakistan tenuousatbest. Theleadingevidenceofthesevariouspressuresondomesticfirmsandindustrieswasthat their loan repayment capacity was compromised, with a consequent rise of NPLs on the banksbalancesheets.EventhoughthepaceofincreaseinNPLsinCY09was muchslower thanCY08,ithasneverthelesstestedtheresilienceofthebankingsectorinthatbankshave beenforcedtobuildcontingencyreservesandprovideforinfectedassets.Suchrequirements affected their dividend payments, putting pressure on their share prices.2 Notwithstanding the various challenges in the economic environment, banks have managed to continue to performwell,asisevidentfromthefactthattheiroverallROA(netoftaxes)is0.9percentin CY09,stilllessthantheconventionalnormof1.0forbanks,butanimprovementoverROAof 0.8 percent in CY08. This indicates their capacity to withstand challenges from their operatingenvironment. Notably, there were also some positive developments during the year. These include a substantialdeclineintheinternationaloilandcommodityprices3whicheasedthepressure ontheexternalcurrentaccountdeficit,improvedcropoutputs,andsubstantialimprovement in banks liquidity position, etc. These various developments helped to mitigate persistent inflationarypressuresandofferedroomforloweringtheSBPpolicyratefrom15.0percent atendCY08to12.5percentduringCY09.Thiseasingofmonetarypolicywasconsistentwith signsofimprovementineconomicindicators.4
1Maincomponentsofcapitalflowsareworkersremittances,foreigndirectinvestment(FDI)andforeignportfolioinvestment (FPI).AlthoughworkersremittancesincreasedfromUSD7billioninCY08toUSD8.7billioninCY09,yetthisimprovementhas been offset by the fall in FDI from USD 5.4 billion in CY08 to USD 2.4 billion in CY09 and further deterioration in FPI from outflowsofUSD269millioninCY08tooutflowsofUSD608millioninCY09. 2CashdividenddistributedbythebankingsectorinCY09declinedby22.8percentonYoYbasisfromRs.26.5billiontoRs.20.4 billion. 3 World Spot Price of crude oil declined from 97 USD/barrel in 2008 to 61.5 USD/barrel in 2009. Using 2000 as base year, HWWAWorldPriceIndexreportsthatcommoditypriceexcludingoilfellfrom184.1in 2008to156.8in2009.Source:Haver AnalyticsDatabase. 4YoYinflationdroppedto17.2percentinAprilCY09fromitspeakof25.3percentinAugustCY08,largescalemanufacturing (LSM) grew by 7.5percent in CY09 against a decline of 2.5 percentin CY08,there was relative stabilityinthe exchange rate whichdepreciatedby6.1percentinCY09asagainst21.9percentinCY08,remittancesgrewbyaround25percenttoreachUSD 8.7billioninCY09,etc.
FinancialStabilityReview200910
DuringCY09,theoverallassetsofthebankingsectorincreasedby15.8percent,amounting toRs.6.5trillion.Therewasanotablechangeinthecompositionoftheassetbase,withan increaseof60.0percentinbanksinvestmentsportfolio,constitutingmainlyofgovernment securities, and only a meager increase of 2.1 percent in the advances portfolio. This developmentservedtoincreasetheshareofinvestmentsintotalassetsfrom19.3percentin CY08to26.7percentinCY09.Asaresultofthisportfoliorebalancing,theshareofadvances (netofprovisions)declinedby6.7percent,withanalmostcorrespondingriseintheshareof investmentsby7.4percent.Thesedevelopmentsareindicativeofthechangingriskappetite ofbanksandthedemandpressureontheloanablepooloffunds,withaperceptibleshiftin creditallocationfromtheprivatetopublicsector.Theincreaseinassetswasfundedlargely bydepositswhichincreasedby13.5percentinCY09,asagainst9.4percentinCY08. Banksresiliencetowithstandadversedevelopmentscanbeassessedbythestrengthoftheir equity base. Capital is considered to be an important indicator of banks loss absorption capacity.InCY09,banksequitybasewidenedbyahealthy17.3percentasagainstonly3.4 percent in CY08. Increase in banks minimum capital to Rs. 6.0 billion by endCY09 in line withSBPsrequirementsleadtoanincreaseintheaggregateriskweightedcapitaladequacy ratio(CAR)to14.0percentinCY09,comparedto12.2percentatendCY08,wellabovethe requirement5 of 10.0 percent. Of the 40 banks in the banking sector, 27 banks had their respective CAR in excess of 12.0 percent, and are considered as wellcapitalized banks. However6bankswerebelowtheminimumrequiredlevelof10.0percentforCY09. In linewith theshiftin asset composition,the creditrisk profile ofthe banking sector also underwentamajorchangeduringCY09.Theloanportfolio(netofprovisions)whichgrewby 18.0 percent in CY08, expanded by a mere 2.1 percent in CY09. Major factors behind the overalldeclineinthegrowthrateofloansinclude:(1)ashiftinbanksriskpreferencesfrom lending to the private sector to investments in riskfree government securities, and (2) declineincreditdemandduetothegeneralslowdownintheeconomy. Atthesametime,theYoYgrowthingrossNPLs,themainindicatorofcreditrisk,decelerated to24.2percentinCY09from64.8percentinCY08.AsopposedtoCY08whenthefirstthree categoriesofNPLsclassification6hadcontributed62.4percenttotheoverallgrowthinthe stockofNPLs,thecumulativeincrementalcontributionofthesepartiallyprovidedcategories declined to 4.7 percent in CY09. Notably, the previous stock of NPLs in these categories deteriorated into the loss category in CY09, increasing its share in total NPLs from 56.0 percentinCY08to65.5percentinCY09.AsNPLsinthelosscategoryarefullyprovidedfor, therewasanincreaseintheshareofprovisionsforthiscategory,from79.5percentto84.5 percent.However,banksavailedthebenefitoftheForcedSale Value(FSV)7oncollateralin makingprovisionssuchthattheincreaseinprovisionswaslessthantheincreaseintheflow of NPLs into this specific category. Notwithstanding the FSV benefit, on an overall basis, increaseinprovisionswashigherthantheincreaseinNPLsduetohighergrowthofNPLsin the loss category. The total provision coverage of the NPLs portfolio at endCY09 was approximatelymaintainedat69.9percentcomparedto69.6percentinCY08. ThepotentialrisktothesolvencypositionisvisiblefromtheslightsurgeinthenetNPLsto capital ratio of the banking system to 20.4 percent in CY09, compared to 19.4 percent for CY08.ThedistributionoftheNPLstocapitalratioacrossbanksindicatesthatmajorityofthe largeandmediumsizedbanks(withanassetshareof61.2percent)havethisratioatbelow theindustryaverage,thoughsomesmallbanks,withcumulative assetshareof7.4percent,
BSDCircularNo.19datedSeptember5,2008. OAEM,Substandard,andDoubtful. 7Detailsinsection4.4.1.
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StabilityoftheBankingSystem
havethisratioinexcessof50percent.Inthepreviousyear,therewereonly4suchbanks, withanassetshareof5.3percent. A key development in CY09 was the easingoff of liquidity pressures experienced in the second half of CY08. The impact of SBP policy actions, which were taken to address the liquidity strain at that time, enabled the banking system to maintain a relatively more comfortable liquidity position in CY09, even though there were intermittent episodes of liquiditystressduringtheyear.Thisisevidentfromthesubstantialriseinbanksholdingsof excessliquidreserves,considerablyabovethestatedrequirementsbySBP. Banks deposit base, the biggest source of funding for banks in Pakistan and inextricably linkedtotheirliquidityposition,grewby13.5percentduringCY09,slightlylowerthanthe averagegrowthof15.3percentsinceCY01,butconsiderablybetterthanthegrowthof9.4 percentinCY08.Thisgrowthwasprimarilycontributedbyincrementaldepositflowsinthe secondhalfofCY09whichiswhendepositsgrewby12.9percent. One of the quantitative performance criteria in the IMF Standby Arrangement (which the countryenteredintoinNovemberCY08)pertainstotherestrictionofgovernmentbudgetary borrowings from the central bank in the form of endquarter targets. Consequently, the Government resorted to borrowing from commercial banks.8 This is one of the primary factorsbehindtheincreaseinbanksholdingsofliquidreserveswellabovetherequiredSLR. Inadditiontothis,therelativelymorecomfortableliquiditypositioninCY09isattributedto: (1)meagergrowthincredittotheprivatesectorduetobothbanksriskaversetendencies giventherisingnonperformingloanportfolio,andsubdueddemandforcredit;(2)improved remittances and deposit mobilization; and (3) the introduction of the explicit interest rate corridor facility which facilitated liquidity management for market participants. In particular,theimplementationofthisfacilitywasakeypolicymeasureimplementedduring theyear,aimedatreducingthevolatilityinovernightrates,inadditiontomakingmonetary policy implementation effective and transparent. Improved liquidity position was also evident from the various liquidity indicators in CY09: the liquid assets to total assets ratio stood at 32.7 percent in comparison to 28.2 percent in CY08, whereas the advances to depositratiodeclinedto63.4percentfrom71.3percentinCY08. Intermsofbanksearningsperformance,overallprofitability(netoftax)exhibitedariseof 25.7percentinCY09,whichledtoaslightimprovementinthe ROAto0.9percentinCY09 relative to 0.8 percent in the previous year. This profitability position was however somewhatskewedratherthanbroadbased,since11bankswithacumulativemarketshare of62.3percentrecordedaboveaverageprofits,and10outof40bankswithassetshareof 60.4percenthadtheirrespectiveROAatmorethan1.0percent. While the overall performance and stability assessment of the banking sector has been summarizedintheintroductorysection,therestofthechapteranalyzesthedetailsofthese developments.Thechapterisorganizedintofivesections.Section4.2assessestheassetand funding structure of banks. The impact of these changes on various risks to the banking sector is analyzed in section 4.3. Section 4.4 examines the ability of the banking sector to absorblossesstemmingfromchangesintheriskfactors,whereasthefinalsectionconcludes thechapter. 4.2AssetandFundingStructure Assets ofthe banking system exhibited agrowth of15.8 percent to reachRs6.5 trillionby endCY09,surpassingtheaverageannualgrowthof14.8percentsinceCY01.Bankassetsasa
8DetailsinChapter2:GovernmentBorrowingsfromtheBankingSystem:ImplicationsforMonetaryandFinancialStability,in thiseditionoftheFSR.
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proportionofGDPstoodat47.4percent,undergoingasmalldeclineof1.6percentinCY09 relativetothepreviousyear(Figure4.1).Onthefaceofit,theincreaseintheassetbasewas aremarkableachievement,especiallygiventhegrowthofonly8.8percentinCY08. However,akeycharacteristicofthisgrowth Figure4.1:Bank Assets ChangeinAssets(rhs) BankAssetstoGDP was the significant expansion in investments instead of the advances 60 1000 900 portfolio.Investmentsgrewby60.0percent, 50 800 such that their share in the consolidated 700 40 600 assetbaseofthebankingindustrysurgedto 30 500 26.7 percent by endCY09, relative to 19.3 400 20 percentinCY08.Acloserlookatbankwise 300 200 10 investments reveals that foreign banks 100 recordedthehighestgrowthininvestments 0 0 (132percent).Giventhatamongthevarious categories of banks, growth rate of NPLs Source:BSD,SBP was the highest for foreign banks in CY08 and CY09,9 it is not surprising that this Figure4.2:Asset CompositionoftheBankingSystem particular group of banks is more risk Advances Investments aversethantherest. Cash&Balances Others 64 56 In line with these developments, there has 48 also been a structural shift in the overall 40 composition of assets with an increase in 32 the share of investments by 7.4 percent in 24 CY09, and an almost corresponding decline 16 in the share of advances by 6.7 percent 8 (Figure4.2).Reasons attributedtothe rise intheinvestmentportfolioofbanksinclude factors such as: (1) change in banks risk Source:BSD,SBP perceptionduetomountingnonperforming loans (NPLs), and (2) greater borrowing Figure4.3:DecadewiseScatterofBankConcentration needs of the government from scheduled 25 banks for budgetary purposes, for settling intercorporate receivables and to finance 20 commodityoperations. 15 In terms of concentration in the banking 10 sector, the share of individual banks assets 5 in the total asset base continues to decline as the industrys competitive position 0 gradually improves. Two big banks, which 0 5 10 15 20 held a cumulative share of 38.7 percent in 2009 thetotalassetbaseofthebankingsectorin Source:SBPCalculations CY00, have seen their share drop to 27.1 percentoverthelast10 years(Figure4.3). However,forCY09,ananalysisofbanksasset base indicates that 7 small banks,10 with a cumulative share of 4.0 percent, registered negativegrowthintherangeof7.5to30.1percentduringCY09.Amoretraditionalmeasure of concentration, the Mconcentration ratio, shows that the smallest5 banks have a cumulativemarketshareoflessthan1.0percent,indicatingmarketfragmentation.
CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 percent CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY09 CY08
9 10
118.4percentand107percentrespectively. Theseinclude3domesticprivatebanks,2specializedbanksand2publicsectorcommercialbanks.
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2000
CY09
billionRupees
percent
A decline in the concentration of large banks is also evident from the fact that the market share of the big 5 banks decreased by 160 bps to 50.8 percent during the year. The HerfindahlHirschmanIndex(HHI),11anotherwidelyusedmeasureofmarketconcentration which takes into account both the relative size and number of banks in the industry, also showsthatconcentrationinthebankingsector,especiallyforthebiggestplayers,continues todeclineovertime(Table4.1).
Table4.1:MeasuresofConcentration percent HHI CoefficientofVariation MConcentrationRatios Shareoftop5banks Shareoftop10banks Shareofsmallest5banks Source:SBPcalculations 63.2 76.5 0.7 61.2 75.8 0.6 60.8 76.7 0.4 58.8 75.1 0.3 56.0 73.1 0.5 54.0 72.5 0.5 52.3 75.1 0.6 52.0 74.6 0.6 52.4 73.6 0.6 CY00 1023 1.9 CY01 993 1.8 CY02 973 1.7 CY03 912 1.6 CY04 850 1.5 CY05 762 1.4 CY06 745 1.4 CY07 739 1.4 CY08 735 1.4 CY09 712 1.4 50.8 73.0 0.5
Disaggregated analysisof assets shows that advances, which form the majorcomponentof banks asset base with a share of around 50 percent at endCY09, recorded a marginal growthof2.1percentduringtheyear.Heightenedelementofcreditriskduetosurgeinnon performingloanscoupledwithlowdemandforcreditcontributedtothenegligiblegrowthin advances. Onthe liabilityside, deposits ofthe banking system registered a significantgrowth of13.5 percentinCY09,higherthanthe9.4percent increase in CY08, despite the stiff Figure4.4:TrendsinCurrencytoDepositsRatio&MM competition posed by instruments of the MoneyMultiplierLHS CICtodepositsratioRHS 42 3.5 NationalSavingsSchemes(NSS).12Trendsin 36 3.4 deposit mobilization indicate that the 30 3.3 growth in deposits was primarily 24 3.2 concentratedinthesecondhalfoftheyear, 18 3.1 asbanksdepositbasegrewby12.9percent 12 3.0 in H2CY09. Increase in deposits in the 6 2.9 latterhalfoftheyearislargelyattributedto 0 2.8 monetary expansion on the back of rising Net Domestic Assets (NDA) (due to substantial government borrowing) and an increase of 23.9 percent (in US$ terms) in Source:BSD,SBP home remittances, an important source of bankdeposits(Figure4.4). Dissectingtheincreaseindepositsrevealsthatincrementalflowswereprimarilyrecordedin demanddeposits(currentandsaving).Thisisincontrasttothetrendinthepreviousyear, wherefixeddepositsrecordedanincreaseof26.3percent.Inamacroeconomicenvironment of the then prevalent monetary easing and declining interest rates, banks focused on mobilization of demand deposits instead of fixed deposits so as to contain the cost of deposits.Analyzingtheincreasein depositsintemsofvariousdepositholdersrevealsthat theincreasewasprimarilycontributedbydepositsofGovernmentandNonFinancialPublic SectorEnterprises(PSEs).Thesecategorieshaveacumulative shareof18.8percentinthe
percent
11 12
ThecalculatedvaluesofHHIarelessthan1000:alevelbelowwhichmarketstructureisconsideredtobecompetitive. DetailsinChapter3,RoleoftheGovernmentinPromotingSavingsinthiseditionoftheFSR.
Dec06 Mar07 Jun07 Sep07 Dec07 Mar08 Jun08 Sep08 Dec09 Mar09 Jun09 Sep09 Dec09 Mar10 Jun10
percent
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depositbase.Giventhatmorethan70percentdepositsofgovernmentbodiesareclassified asdemanddeposits,anysignificantgrowthinthiscatgeoryofdepositspartiallyexplainsthe overallincreaseindemanddeposits. Borrowings from financial institutions, another key component of liabilities, witnessed a substantial growth of 42.3 percent in CY09, in sharp contrast to the meager growth of 1.7 percentinCY08.InCY09,theseborrowingsmainlyconstitutedofborrowingsfromSBP(for EFSandLMM),andrepurchaseagreementsintheinterbankmarket.Dissectingtheincrease inborrowingsonaquarterlybasisrevealsthatborrowingsspecificallyincreasedduringthe latter half of the year, due to liquidity constraints in December CY09 emanating from less thanexpectedretirementsforcommodityoperationsandslowerNFAinflows. Lastly,theequitybaseofthebankingsectorincreasedbyasubstantial17.3percentduring CY09, compared to only 3.4 percent in the previous year. Banks were required to increase their minimum capital to Rs 6.0 billion by endCY09 which contributed to this increase. Notably,banksminimumcapitalrequirement(MCR)wasrationalizedbytheSBPinCY09.13 TheMCRwasrevisedinviewoftheprevalentchallengingeconomicenvironment,whichhad negativeimplicationsforbanksprofitabilityandconsequentlytheirreserveaccumulation. Analyzing the growth in equity base in CY09 reveals that revaluation gains contributed significantly to this growth. Compositional breakup of revaluation gains reveals that the banking sector booked a gain of Rs 5.0 billion on equity investments due to the relative stabilityintheequitymarketinCY09,afterthefreefallofthestockmarketfromAprilCY08 onwards which led to the imposition of the floor on the KSE100 index in August CY08. Moreover,revaluationgainsofRs6.8billionwererecordedonotherinvestments,including derivativestransactions. 4.3AssessmentofRisks While the global financial system continues to recover gradually, the risk of potential aftershocks14remainssizable.Onthedomesticfrontthereweresomemacroeconomicgains during CY09 however theeconomy facedchallengessuch as fiscalimbalances,pressure on balance of payment, circular debt, energy crisis, etc. These risks have had their bearing on thesizeaswellasthestructureofbanksbalancesheets.Giventheunprecedentedscaleand scopeofsuchtremors,bankscontinuallystrivedtoadapttotheevolvingenvironment.The impactofthesedevelopmentsonthebankingsectorsriskprofileisanalyzedinthefollowing sectionsintermsofcredit,market,operationalandliquidityrisk. 4.3.1CreditRisk The indirect impact of the global recession and slowdown in domestic economic activities increased the potential risk of losses for banks, particulalry since endCY08, due to the increaseintheprobabilityofdefaultofoutstandingloans,withtheimpairmentofborrowers repayment capacity. Economic recovery is now underway in most of the developed world, with the pace and strength of the rebound differing across countries, depending on the severity of the crises hitting respective regions. World output 15 which had fallen to 0.6 percentin2009,isexpectedtoriseby4.8percentin2010,drivenlargelybythegrowthin emerging economies like China and India. Domestic economic growth also plummeted by
BSDCircularNo.7,datedApril15,2009. A variety ofaftershocks areunfoldinginthe current phase ofthe crisis. Majorrisks include management ofthe mammoth fiscaldebtswhichhavethepotentialtotriggeranotherroundofinstability.Giventheintroductionofnewlegalreforms,there would be increasedscrutinyand oversight offinancial institutions which would increasethe costof doing business.There is alsothepressuretoidentifyandseparateweakinstitutionsfromstrongeronesandlaydownacostminimizingframeworkfor their exit from the market in crisis times; and there are ramifications for international financial institutions to update their chartersandimprovetheircapacitytodesignandimplementstricterstabilizationandstructuralprogramsincountrieshitby shocksandcrisis.Source:IMFpapersandspeeches. 15WorldEconomicOutlook,October2010,IMF.
13 14
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250 bps to reach 1.2 percent in FY09, but recovered thereafter to reach 4.1 percent in FY10.16 Theinverserelationshipbetweencreditrisk Figure4.5:Advances,NPLs,GDPGrowth* and overall economic activities is a well Advances NPLs GDPgrowth(RHS) establishedfact,andalsodiscussedindetail 75 10 inlastyearsFinancialStabilityReview.17In 60 8 line with the analysis, the gradual 45 6 improvementineconomicindicatorshasled 30 4 to a deceleration in the growth in NPLs: 15 2 from64.8percentinCY08to24.2percentin 0 0 CY09(Figure4.5). 15 2 30 4 Notwithstanding the deceleration in NPLs, credit risk is the key challenge in the *RealGDP(FC) hasbeencalculatedonfiscalyearbasis. banking system. An assessment of the loan Source:BSD,SBP portfolio ofthe banking system will help in understandingthemovementsinassetqualityindicatorsduring theyear.Banksadvances portfolioincreasedbyRs.67.1billioninCY09,translatingintoagrowthrateof2.1percent,a sharpdeclinefromthegrowthof18.0percentinCY08.Thisminisculegrowthismuchless than the average growth of 15.9 percent over the last ten years, and is actually the lowest growth in net advances in the last seven years. Among various factors, there was a significant change in the lending behavior of local private banks, which constitute three fourthsofbankingsectorloans:theiradvancesgrewbyaminiscule0.2percent(YoY)during CY09. Banksloanclassificationbymajorsegments Table4.2:SegmentwiseDistributionofLoans indicates that in line with the overall slow percentshareintotalloans growth in advances, the shares of loans to Growth the corporate sector, SMEs, Agriculture and CY07 CY08 CY09 CY09 Consumer Finance all declined in CY09. The Corporate 56.3 63.2 61.9 2.5 only substantial increase seen was in the SMEs 16.2 11.7 10.4 7.2 share of commodity finance which grew by Agriculture 5.6 4.9 4.7 0.7 around 78 percent during the year, with a Consumer 13.8 10.4 8 19.1 corresponding increase in its share in total Commodity 5.5 7.4 12.5 77.8 loans(Table4.2).Giventhedeteriorationin Miscellaneous 2.7 2.4 2.5 5.1 the quality of loans for SMEs and consumer percentshareinConsumer financeinparticular,banksshowedhighrisk Creditcards 12.6 12.3 11.6 23.3 aversion in extending new loans to these Autoloans 30 28.7 24.7 30.5 segments. As a result, their respective Durables 0.3 0.1 0.1 51.8 growth declined by 7.2 percent and 19.1 Mortgage 18.1 20.2 22.9 8.1 percent on YoY basis. Notably, the negative Personalloans 38.9 38.8 40.7 15 growthinconsumerfinanceiscontributed Source:BSD,SBP bythesharpdeclineintheYoYgrowthofall Table4.3:LoanclassificationbyenduseforCorporate itscomponents,somemorethanothers. andSMEs percentgrowth Table 4.3 focuses on the growth rate of Enduse CY07 CY08 CY09 loans to firms (both corporate and SMEs). FixedInvestment 21.1 21.1 13.7 This classification explains the nature of TradeFinance 23.6 15.6 8.1 allocation of funds for investment purposes WorkingCapital 10.0 25.7 9.9 (e.g.plantexpansion)andoperationalneeds
percent CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08
Source:BSD,SBP
16 17
TheStateofPakistansEconomy200910,StateBankofPakistanAnnualReport,Volume1. SpecialSection1:GrowthinNPLs,CyclicalorStructural,FinancialStabilityReview200809,StateBankofPakistan.
CY09
percent
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(e.g.buildinginventories)ofthefirms.ComparedtoCY08,therewassubduedgrowthinall threecategoriesofloansfixedinvestment,workingcapitalandtradefinanceduringCY09. In particular, working capital loans, which form a major proportion in this classification, showthehighestdeclineingrowth,from25.7percentinCY08to9.9percentduringCY09; againavisibleindicationoftheslowdownintheeconomy. The structure of interest rates in the Figure4.6:TrendsinKeyInterestRates economy is another important determinant 6mKIBOR WALR SBPReporate ofcreditriskinthebankingsector.Interest 16 ratevolatility,besidesaffectinginterestrate 15 risk, alters the cost of borrowing which is 14 13 inextricably linked to the repayment 12 capacityoftheborrowers.Figure4.6shows 11 trendsinleadinginterestratesliketheSBP 10 repo rate, which sets the tone of the term 9 structure of interest rates, alongwith the 8 weightedaverage lending rate (WALR) and the6monthKIBOR,whichisthebenchmark forpricingloans.WiththestartofCY09,two Source:S&DWH,SBP developmentstookplacewiththeeasingin the monetary policy stance: (1) lending rates in the primary as well as secondary market starteddeclining,and(2)interestratevolatility,whichaggravatesuncertaintyinthesystem, startedsubsiding.TheintroductionoftheinterestratecorridorinAugustCY09provedtobe instrumental in stabilizing the overnight money market repo rate. As the level of interest rate directly impacts the cost of borrowing, therefore any reduction in its level as well as volatilityhelpsinmanagingthecreditriskprofile. Table 4.4 gives details on advances by type of borrowers. This table shows the Table4.4:ClassificationofAdvancesbyBorrowers government as a dominant borrower of the AmountinbillionRupees YoYgrowth(%) banking sector in CY09:18 compared to the CY08 CY09 CY08 CY09 increase of 93.6 percent in CY08, Government 150.5 333.4 93.6 121.6 government borrowing from commercial 186.9 225.4 49.0 20.6 banks for commodity operations more than NonfinancialPSEs PrivateSector 2,240.8 2,221.5 18.9 0.9 doubled during CY09 (compared to CY07, o/wmanufacturing 1,299.4 1,282.4 19.0 1.3 government has borrowed more than four Allothers 478.3 411.5 8.9 14.0 times in CY09). Consolidated banking data shows that the share of the government Source:StatisticalBulletin,SBP sectoringrossloansincreasedfrom11.1percentinCY08to17.4percentinCY09.Thesteep riseingovernmentborrowingswasonaccountof:(1)onlypartialretirementofgovernment borrowings for commodity operations which are generally selfliquidating in nature (with potential risk of another circular debt building up similar to the one in the energy sector), and(2)increaseddemandforbankcreditduetoriseincommodityprices.
percent Apr07 Apr08 Apr09
Despite the lingering issue of intercorporate debt 19 in the energy sector, low advances disbursementtoafewPOLrelatedPSEslimitedthenetexpansionofPSEsadvancesinCY09, comparedwithastrongincreaseinCY08.Thisdecelerationwasinawayexpected,giventhat somePSEshadavailedbankadvancesmoreaggressivelyinCY08andhadthusalmostfully
18Unlikefiscalmeasuresinadvancedcountrieswheregovernmentdeficithasballoonedonthebackofheftyfinancialsupport programs for ailing financial institutions, fiscal challenges in Pakistan emanate from the low taxbase, excessive current expenditures, heavy subsidies to selected sectors, expenditures on war on terror etc., all of which leads to the governments dependenceonborrowingfromthebankingsystem. 19 Intercorporate debt is a situation where a company facing problems in its cash flows tends to withhold payments to its supplierssuchthatthesuppliersarethenforcedtostopmakingpaymentstotheircreditors.
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Jul09
Jan10
utilizedtheirprescribedcreditlimitswithvariousbanks,particularlyinH1CY09.Therefore some banks were reluctant to extend incremental advances to these entities. With the issuance of two Privately Placed Term Finance Certificates (PPTFCs)20 in CY09, a few POL relatedPSEshadsettledsomeoftheirloanobligationswithbanks,however,itwasobserved that they subsequently again sought advances from banks as they got room for fresh borrowing. On the other hand, loans to the private sector showed net retirement of 0.9 percentinCY09,comparedtothegrowthof18.9percentinCY08. The shift in the classification of loans by borrowers and segments seem to be in line Table4.5:DistributionofLoansbySize with banks general approach to credit risk Shareinpercent,AmountinmillionRupees CY08 CY09 management during a period of gradually reviving economic growth, by reflecting a LoanSize Account Share Account Share preference to transact business with the UptoRs0.1 70.3 5.0 66.8 4.1 government and with large, strong UptoRs1.0 96.9 15.6 96.3 12.9 counterparties to contain credit risk. UptoRs10.0 99.5 28.3 99.4 24.7 Notably, these changes in the overall loan OverRs10.0 0.5 71.7 0.6 75.3 portfoliohaveincreasedtheelementofcredit SourceSBPcalculations concentration risk in the banking system. Table 4.5 shows the distribution of loans by size of account. Consistent with observations made earlier, data shows that at the end of CY09, only 0.6 percent of the total number of borrowers with loan sizes of Rs. 10 million and above, had availed 75.3 percent of outstandingloans,asagainst71.7percentinCY08.Theaverageloansizeforthisparticular categoryhasalsoincreasedfromRs77.6millioninCY08toRs87.1millioninCY09.Onthe other hand 96.3 percent of borrowers with loan size of Rs. 1.0 million (or below) have a share of only 12.9 percent in the total loans of the banking sector. This indicates a severe degree of concentration of outstanding credit in the hands of a few large borrowers, and carries potential systemic implications for the banking system, where such clients have creditlineswithbanksacrosstheindustry. Sectorwise distribution of loans to the Table4.6:InfectionRatiobySectors private sector also highlights credit risk percent CY09 concentration as loans to the textile sector CY08 alone constitute 20 percent of banks loans Chemical&Pharmaceuticals 7.7 6.7 portfolio.Henceboththehighinfectionratio Agribusiness 8.9 8.9 of these loans, as evident in Table 4.6 Textile 14.6 19.6 (discussed in detail below) and the small Cement 6.6 12.2 number of big borrowers reflect the Sugar 9.1 19.6 increasing element of credit concentration Shoes&Leathergarments 8.6 13.3 risk. Automobile&Transportationequipment 7.5 16.6 Financial 5.4 12.6 In addition to the analysis of the quantum Insurance 0.0 0.1 and various classifications of banks loan Electronic&Transmissionofenergy 3.4 7.4 portfolio, it is important to investigate the Others 8.6 10.6 quality of loans in terms of their Source:BSD,SBP performance,inordertoassessthedegreeof creditriskfacedbythebankingsector.Banksfinancialperformanceisdirectlyproportional
Toresolvetheintercorporatedebtissueintheenergysector,thegovernmentissuedPrivatelyplacedTFCs(PPTFCs)(against governmentguarantee)twiceinCY09foracumulativeamountofRs.165billion:thefirstPPTFCworthRs.80billionwasissued in March CY09 by PEPCO and a second PPTFC worth Rs. 85 billion was issued in September CY09 by the Power Holding Company.ThepurposeofissuanceofbothPPTFCswastoreducepartofbanksclaimsonpublicandprivatesectorenterprises andshifttheoutstandingdebttothegovernmentthroughadebtswap.
20
57
to the performance of their loans portfolio, Figure4.7:AnnualChange inNPLsoftheBanking themainstayoftheirearnings.DuringCY09, Sector NPLs increased by Rs 73 billion to Rs 432 160 140 billion(Figure4.7).Encouraginglythough, 120 afterhavingincreasedbyRs.141.3billionin 100 CY08, the growth rate of NPLs decelerated 80 from 64.8 percent to 24.2 percent in CY09. 60 40 Except for 3 specialized banks (whose 20 lending facilities are relatively inactive as 0 mostofthemareunderrestructuring)and1 20 40 private commercial bank, the rise in NPLs was observed across the entire banking system. Source:BSD,SBP Given the strong correlation of NPLs with Figure4.8:CategorywiseBreakupofNPLs economic activities, a major portion of the OAEM Substandard Doubtful Loss increase in NPLs since CY08 was primarily of a cyclical nature due to the deceleration CY09 in real GDP growth, with negative CY08 implications on incomes and hence the repayment capacity of the average CY07 borrower. In a similar vein, the gradual CY06 process of economic recovery has had an impact in slowing down the accelerated CY05 pace of growth of NPLs in CY09. The 0 100 200 300 400 500 classificationofNPLsintovariouscategories billionRupees lendscredencetothisobservation,asunlike Source:BSD,SBP CY08 when the first three categories contributed62.4percentinthegrowthofNPLs,inCY09theircontributiondeclinedto4.7 percent. Notwithstanding, NPLs booked in partially provided initial categories in CY08 maturedintolossesduringCY09,andasaresulttheshareofthelosscategoryintotalNPLs increased(Figure4.8).However,banksavailedtheFSVbenefitinmakingprovisions,hence the increase in provisions was less than the flow of NPLs in this category, such that the provision coverage ratio of the loss category declined from 92.3 percent in CY08 to 86.2 percent in CY09. On an overall basis, however, provisions have increased more than the increaseinNPLsdespitetheFSVbenefitsimplybecauseofthehighergrowthofNPLsinthe losscategory.21 Table4.7:DistributionofNPLs percent,number NPLs as a proportion of the loan ratio CY07 CY08 CY09 portfolioalsoincreasedfrom10.5percentin NPLstoloanRatio% 7.6 10.5 12.6 CY08 to 12.6 percent in CY09. Bankwise NumberofBanks information suggests that this increase was 13 15 18 widelysharedbybanks.22Thedistributionof <average >average 26 25 22 banks based on this ratio shows that <5.0 20 13 4 comparedto15banksinCY08,bytheendof 5<10 9 10 13 CY09therewere18bankswiththeirNPLsto 2 5 10 loan ratio below the average ratio for the 10<15 15<20 3 3 3 industry.Inaddition,Table4.7showsthatin >20.0 5 9 11 comparisonwith17bankswithdoubledigit Source:BSD,SBP
billionRupees CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08
21 22
Detailsinsection4.4.1. Banksizewisedistributionhighlightsthattheinfectionrationishighforsmallbanksandlowforlargebanks.
58
CY09
NPLstoloanratiosinthepreviousyear,therewere24suchbanksinCY09,outofwhich11 bankshadthisratioinexcessof20percent.Thisrisecantosomeextentbealsoattributedto thefactthattheloanbookdidnotincreaseduringtheyear,whiletheoutstandingstockof NPLscontinuedtogrow,albeitataslowerpace. Irrespective of the factors responsible for Figure4.9:Provisions &BadDebtWrittenoffDirectly therisingvolumeofNPLs,thehighinfection 120 ratio has implications for the overall 100 financial performance of banks. During CY09, banks booked Rs. 97 billion as loan 80 lossexpenses,lowerthantheamountofRs. 60 106.1 billion booked in CY08 (Figure 4.9). 40 This slight reduction is in line with the decelerated growth of NPLs and the FSV 20 benefit allowed in CY09. However, these 0 expenses carry implications for banks profitability,especiallywhenmajorityofthe outstanding NPLs (65.5 percent) are Source:BSD,SBP categorized in the fully provided loss category.Nevertheless,adeclineintheflow Figure4.10:ProvisionsAgainst NPLs of fresh NPLs indicates that in CY10, the Provisionsheld(RHS) provisioningrequirementwouldfall,witha ProvisionstoNPLsRatio(LHS) consequent positive impact on banks 105 350 bottom line. As mentioned earlier, 90 300 75 250 provisioning coverage was maintained in 60 200 CY09 and stood at 69.9 percent of NPLs 45 150 compared to 69.6 percent in CY08. Given 30 100 that banks have focused more on 15 50 investments in expanding their asset 0 0 portfolio,especiallyinriskfreegovernment securities, therefore future provisioning requirements are not expected to rise Source:BSD,SBP substantially. Nonetheless, banks need to step up their efforts to improve the quality Figure4.11:TrendsinNetNPLs of the loan portfolio by closely monitoring NetNPLs(LHS) NetNPLstoLoanratio(RHS) loan recovery prospects and restructuring 14 154 ofexistingclassifiedloans(Figure4.10). 12 132 10 110 TheamountofnetNPLs,anotherimportant 8 88 indicator of asset quality, also reached Rs. 6 66 147 billion in CY09, from Rs. 121 billion in 4 44 CY08 (Figure 4.11). Consequently, the net 2 22 NPLs to loans ratio deteriorated during the 0 0 year: from 3.4 percent in CY08 to 5.0 percentinCY09. Source:BSD,SBP Whilesomedeteriorationinallassetquality indicators and the increased degree of concentration risk is patently obvious, a review of segmentwise NPLs shows that asset qualityhasdeterioratedinalmostallsegmentsofloans(Table4.8). Theinfectionratioforthecorporatesector,whichconstitutes61.9percentoftotalloans,has increasedfrom8.9percentinCY08to12.6percentinCY09.Consequentlybankshave
billionRupees CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08
billionRupees
CY09
CY00
CY01
CY02
CY03
CY04
CY05
CY06
CY07
CY08
CY09
percent
billionRupees
percent
CY09
59
showedreluctanceinextendingcredittothe Table4.8:SegmentwiseNPLstoLoanRatioofthe corporatesectorwhichisalsoreflectedfrom BankingSector theincreaseofonly2.5percentofcorporate percent loans in CY09. As stated elsewhere, due to CY06 CY07 CY08 CY09 the general slowdown in economic activity, Corporate 6.5 7.2 8.9 12.6 theloanrepaymentcapacityofthecorporate SME 8.8 9.4 15.8 22.1 sector came under stress which is evident Agriculture 20.8 18.7 15.8 16.5 from the steep rise in its NPLs by 43.3 Consumers 2.2 4.4 6.9 12.2 percent, which is in sharp contrast to commodityfinance 0.6 1.0 1.4 1.1 previousyearswheretheNPLstoloansratio Overall 6.9 7.6 10.5 12.6 of the corporate sector was consistently Source:BSD,SBP below the overall infection ratio. This deterioration of the corporate sectors loan portfolio emanates largely from the high infection ratio of loans to the textile sector, and points to the need for close monitoring of theseloanswhicharealikelysourceofsystemicriskgiventheirproportionintotalloans. The infection ratio for consumer finance, in Table4.9:NPLstoLoanRatiooftheConsumerSegment particular, almost doubled in CY09, leading percent banks to cut back their exposure to this CY06 CY07 CY08 CY09 sectorby19.1percent(Table4.9).Thereare Consumer 2.2 4.4 6.9 12.2 many contributing factors to this CreditCard 1.4 3.4 5.5 11.6 deterioration:inparticular,NPLsfromcredit AutoLoans 1.9 4.6 5.9 8.5 cards have increased by 62.3 percent while Durables 9.8 9.8 7.8 9.9 facing a reduction of 23.0 percent in credit Mortgage 1.8 5.4 7.4 15.5 disbursement, resulting in more than PersonalLoan 2.7 4.1 7.8 12.4 doubling of the infection ratio in this sub Source:BSD,SBP segment, and similarly NPLs for mortgage loans have increased by 98.4 percent. Given the overall share of 22.9 percent of mortgage loansinconsumerloans,thisisareflectionoftheneedforimprovementinbankscreditrisk appraisalsystems. In sum, the detailed analysis of asset quality indicators and the classification of the loan portfoliobyvariousdimensionspointtowardstheincreasedelementofcreditconcentration withthegraduallydissipatingelementofcreditrisk,giventheshiftinbankassetallocation fromadvancestoinvestments.Whileassetqualityindicatorsdeterioratedfurtherduringthe year,thecompositionofthestockofNPLsatendCY09showsa lowdegreeofincremental NPLflowswhichisanencouragingdevelopment,andbodeswellforcontainingprovisioning expensesinCY10. Notably,concentrationrisk,intermsof:(1)fewbigborrowers,(2)exposuretothecorporate sector (and the consequent lack of diversification in financing options) and (3) sectoral concentrationofloans,asinthecaseofthetextilesector,carriessignificantimplicationsfor theoverallriskprofileofthebankingsector. 4.3.2MarketRisk Relative stability in both international and domestic financial markets during CY09 contributed to a low degree of market risk for banks. This section presents market risk analysis in terms of its three major components; interest rate risk, exchange rate risk and equitypricerisk. Togiveanoverallperspective,SBPsmonetaryeasingstanceinCY09hadabeneficialimpact ontheelementofinterestrateriskforbanks.Additionally,theimprovedliquiditypositionin CY09, in addition to subsiding interest rate volatility, also provided stability in both the money market and the foreign exchange market. Hence exchange rate risk also remained
60
low on account of improved foreign inflows and rising remittances during the year. Lastly, equity prices also recovered during the year, leading to substantial revaluation gains on banksinvestmentsinequity. Interest Rate Risk: Among the various market risk factors, interest rate risk is the most significant for banks in Pakistan, as around 71.3 percent of their investments are in fixed incomegovernmentsecurities.Ontheliabilityside,although31.9percentofbanksdeposits are categorized as fixed deposits, the PLS nature of these deposits tends to give banks the flexibilityinmanagingtheircostoffunds. Figure4.12:ShortTerm InterestRateVolatility Volatility(RHS) 7DaysPKRV PolicyRate CY09 started with the SBP policy discount 18 3 rateatitsmaximumlevelof15.0percent.23 It was reduced on three instances during 15 2.5 CY09: first by 100 bps in April, then by 12 2 another100bpsinAugust,andfinallyby50 9 1.5 bps in November CY09. This downward 6 1 trend in short term interest rates was 3 0.5 accompanied with a decline ininterest rate 0 0 volatility.Thecorrespondingdecreaseinthe short term revaluation rate along with increased volatility (proxied by 7 days standard deviation) is visible from Figure Source:FMAandSBP 4.12 which shows higher volatility in the beginningofCY09,anindicationoftheuncertaintyandliquiditypressuresprevalentinthe market at that time. However, by early April CY09 the volatility subsided and the 7days PKRVmovedwithinabandof10.1to12.9percentduringJuneDecemberCY09,comparedto 8.3 to 13.6 percent during JanuaryJune CY09. Albeit there was another period of interest rate volatility in JuneAugust CY09, subsequent to which it remained largely contained mainlyonaccountoftheintroductionoftheinterestratecorridor.24
percent
Analysisofinterestratesisakeyfactorinidentifying,measuringandmanagingtheelement ofmarket riskforbanks.Apartfromitsroleinthedeterminationofcreditrisk,changesin interestrateshaveadirectbearingontheinvestmentportfolioofbankswhichinCY09has grown substantially and constitutes a share of 26.7 percent in total assets, relative to 19.2 percent in CY08. Further breakup of the investment portfolio shows that 71.3 percent of total investments are in fixedincome government securities, followed by 16.9 percent in TFCs,debentures,andcorporatebonds,and3.4percentinfullypaidupordinaryshares. Besidesimpactingshortterminterestrates,thereductioninthepolicyratealsoaffectedthe secondary market yield of government securities. The yields for all types of government securitiesdeclinedinH1CY09,asshownin Figure4.13(a)and(b),withacorresponding downwardshiftintheyieldcurve.Notably,theshiftintheyieldcurvewasnotparallelin Q1CY09itwasflatfortenorsupto10yearsandshowedsteepeningsubsequentlywhilein Q2,theyieldcurveacquired aUshape. Duringthistime,thediscount rate was reducedby 100 bps, and inflation expectations (which define the term premium of longterm interest rates) had started to change. Hence there was a lower demand for shortterm securities whichpusheduptheiryield,andahigherdemandformediumtermsecurities,inparticular 7yearPIBs.
23
Discount rate was increased to 15 percent on 13th November 2008. This was the highest level for the policy rate since 4th March 1999 when it was increased to 15.5 percent. In the last 50 years, the highest ever discount rate was 20 percent in November1996. 24DetailsinChapter7,StabilityAssessmentofFinancialMarkets,inthiseditionoftheFSR.
Jul07 Oct07 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10
percent
61
Figure4.13:SecondaryMarketYields Figure4.13a Dec08 18 17 16 15 14 13 12 11 10 3M 6M 1Y 3Y 5Y 10Y 20Y 30Y Figure4.13b Mar09 16 15 Mar09 Jun09
percent
percent
14 13 12 11 10 3M 6M 1Y 3Y 5Y 10Y 20Y 30Y
Figure4.13c Mar09 15 14
Jun09
Sep09
Figure4.13d Mar09 Sep09 15 14
Jun09 Dec09
percent
13 12 11 3M 6M 1Y 3Y 5Y 10Y 20Y 30Y
percent
13 12 11 3M 6M 1Y 3Y 5Y 10Y 20Y 30Y
Source:Reuters
This development in the yield curve is also Figure4.14:PKRV confirmed by the fact that short term 6M 10Y revaluation rates (6 months PKRV) 17 remained above the long term rates (10 16 years PKRV) between endApril CY09 and 15 endAugust CY09 (Figure 4.14). Negative 14 spreads of 5years and 10year bonds over 13 6months securitybills in Figure 4.15 also 12 pointtothesamefact.However,duringQ3 11 CY09,theyieldcurveshiftedupwardsforall 10 tenorsexceptforthe30yearbond,andlost its Ushape, becoming rather flat for tenors from 3 months to 10 years (Figure 4.13c). Source:FMA andSBP BytheendofCY09,theyieldcurveassumed a more upward sloping shape with slight rationalizationofthetermpremiumfordifferenttenors.Figure4.13dshowstheyieldcurve at endCY09 with lower yields for 3months to 1year instruments, rising somewhat for mediumtermsbonds,withthe maximumyields inbondswithtermshigherthan10years. This again reflects a shift in inflation expectations, with the resurgence of inflationary pressuresandexpectationofreversalofSBPpolicystance. Notably,movementsininterestratesareasourceofrevaluationrisk,whileashiftintheyield curvealongwiththesteepeningofitsslopecreatesyieldcurverisk.Theimpactoftheserisks onthefinancialperformanceofbanksdependsontheextentandnatureoftheirinvestments
percent Feb09 Apr09 Feb10 Apr10 Dec08 Dec09 Jun09 Oct08 Aug09 Oct09 Jun10
62
Aug10
in fixed income securities. Composition of Figure4.15:YieldSpreads from6MTbills the investment portfolio shows that the 5YearSpread 10YearSpread shareoffixedincomegovernmentsecurities 3.5 (Tbills and PIBs) in total investments has 3.0 2.5 increasedfrom66.3percentinCY08to71.3 2.0 25(Figure percentinCY09.Theclassification 1.5 1.0 4.16) ofthesesecuritiesindicatesthat91.2 0.5 percentofthesesecuritieswereclassifiedas 0.0 0.5 Available for Sale (AFS) at endCY09, as 1.0 opposed to 84.2 percent in CY08, while the 1.5 share of Held for Trading (HFT) securities declined from 4.3 percent in CY08 to 1.4 percentinCY09. Source:DMMD,SBP This classification suggests that the impact Figure4.16:ClassificationofFixedIncomeSecurities of any revaluation of securities on banks HFT HTM AFS incomestatementwaslikelytobeminimum 1400 in CY09, as only a small fraction of 1200 investments is classified in the HFT 1000 category. The impact of the revaluation of 800 securities classified as AFS, on the other hand, is taken to the surplus/deficit on 600 revaluation of securities account which is 400 charged against banks capital. Given the 200 favourable interest rate environment, the 0 revaluation deficit on investments in CY07 CY08 CY09 government securities declined to Rs 5.3 Source:BSD,SBP billioninCY09,fromRs18.8billioninCY08. Hence the element of revaluation risk on Figure 4.17:GAP(RSARSL)toAssetRatio banks hefty investments in government PSCB LPB FB SB securities was rather subdued in an environmentofmonetaryeasing. Over5Y Whiletheclassificationofinvestmentshelps 1Yto5Y in understanding the extent of revaluation surpluses / deficits, the overall impact of 3Mto1Y movements in interest rates on banks financial position depends on the gap Upto3M betweenratesensitiveassets(RSA)andrate 2 0 2 4 6 8 10 12 sensitiveliabilities(RSL).Apositivegapina percentofAssets declining interest rate environment is an Source:BSD,SBP adversedevelopmentforthebankingsector as the RSA of banks (which is repriced at lower interest rates) generally exceeds the RSL. Given banks tendency of funding fixed maturity assets generally by demand liabilities, the existenceofthegapisinevitable.Experiencesuggeststhatgapintherangeof+10percentof total assets is considered to be normal for the banking sector. The gap position of the bankingsectorforallcategoriesisinthenormalrangeof+10percentoftotalassets(Figure 4.17).Onanoverallbasis,repricingriskisbeingmanagedwellbybanks. Exchange Rate Risk: Another component of market risk is the currency or exchange rate risk, which arises from a change in the value of foreign currency assets and liabilities of banksduetomovementsintheexchangerate.ThePakRupeehasbeensheddingvalue
basispoints
25
BSDCircularNo.11,datedAugust4,2004.
billionRupees
Oct08 Nov08 Jan09 Feb09 Apr09 May09 Jul09 Aug09 Oct09 Nov09 Dec09 Feb10 Mar10 May10 Jun10 Aug10
63
againsttheUSDollarsinceCY06duetothe Figure4.18:Ex.RateandSwapPointsImplied Rate deterioration in the current account 1weekSwapPoints(RHS) Rs/$ExchangeRate(LHS) balance. The pace of this depreciation 6MImpliedEx.Rate(LHS) pickedupmomentuminCY08,asevidenced 0.30 90 bythetrendsintheexchangerateandswap 0.20 85 points (Figure 4.18). The monthly average 0.10 80 exchange rate indicates that the Pak Rupee 0.00 75 depreciated by 21.9 percent against the US 0.10 70 DollarduringCY08.Thisalmostcontinuous 0.20 65 0.30 60 depreciation over a short period of time, stabilizedbytheendoftheyearonaccount of the SBA with the IMF, which helped in stemming the erosion of the foreign Source:SBP exchange reserves and easing off of concernsaboutthemountingBoPproblems.Subsequently,inCY09thePKR/USDparitywas relativelymorestable,withthePKRdepreciatingby6.1percentonly(Figure4.18).Besides theIMFSBA,thisstabilityisattributedtothesustainedflowofforeignexchangeintheform ofremittances,improvementsinthecurrentaccountbalance,andeffortstocaptureforeign currencyflowsfromtheinformalchannel,foreignexchangedealers,etc. In addition to exchange rate movements, Figure4.19:ResidentFE25Deposits&FE25Loans currencyriskalsodependsontheamountof ResidentFE25Deposits(LHS) foreigncurrencyassetsandliabilitiesofthe FE25Loans(RHS) 4400 2140 banking sector. On the assetside, foreign 4200 1910 currency loans against FE25 deposits 4000 1680 witnessedcontinuousdeclinefromQ2CY08 3800 1450 3600 1220 until endNovember CY09. On an overall 3400 990 basis, FE25 loans declined by 20.2 percent 3200 760 in CY09, compared to a decline of 68.5 3000 530 2800 300 percent in CY08 (Figure 4.19). Specifically, foreign currency loans were only 2.7 percent of total loans as of endCY09, indicating that the banking sector is not Source:S&DWH,SBP inordinately exposed to loans denominated inforeigncurrency. Ontheliabilityside,foreigncurrencydepositsandbanksborrowinginforeigncurrencyare thetwomajorcomponents.Thecurrencycompositionofdepositsindicatesthattheshareof foreigncurrencydeposits(rupeevalue)inthetotaldepositsofthebankingsectorwas14.7 percent at endCY09, as against15.3percentat endCY08. FE25 depositsstarted risingby Q2CY09andgrewby8.8percentduringtheyear,ascomparedtothedeclineof1.4percent inCY08(Figure4.19). Another component of liabilities which can potentially give rise to currency risk is the quantumofbanksborrowingsinforeigncurrency.Thecurrencycompositionofborrowings indicates that the share of foreign currency borrowing in total borrowing was only 3.1 percent at endCY09, as against 7.8 percent in CY08. This fall in the quantum of banks borrowings denominated in foreign currency is a welcome development in terms of containingcurrencyrisk. While the discussion on foreign currency assets and liabilities gives information on banks grossexposuretowardsforeigncurrencyrisks,amoreusefulindicatororbanksforeign
Feb09 Feb10 Apr09 Apr10 Dec08 Dec09 Jun09 Oct08 Aug09 Oct09 Jun10 millionUSDollars
64
Jan08 Mar08 May08 Jul08 Sep08 Nov08 Jan09 Mar09 May09 Jul09 Sep09 Nov09 Jan10 Mar10 May10
millionUSDollars
basispoint
Rupees
currencyexposureistheNet Open Position Figure4.20:NOPofthe Banks (NOP) which includes both on and off 125 balance sheet foreign currency assets and 100 75 liabilities. NOP, which is the net balance 50 sheet exposure of a bank in foreign 25 0 currency,isusedbecauseaportionofgains 25 (losses) on foreign currency liabilities are 50 naturally hedged by losses (gains) on 75 100 foreigncurrencyassets.UnlikeCY08,NOPof 125 the banks fluctuated more in CY09 150 (standard deviation for CY09 is 35.8 as against 31.5 for CY08). However, barring few minor exceptions towards endCY09,26 Source:SBP NOPofbanksremainedwithinthegenerally acceptable narrow range of +USD 100 million in CY09. This shows that banking industry successfully managed exchange rate risk by maintaining positive NOP on average (Figure 4.20). The sensitivity analysis (discussed in section 6.4.3) also indicates that 25 percent depreciation is likely to improve the CAR of the banking sector by 70 bps, while an appreciationby25percentwillcauseittodeclineby10bpsonly.27 Equity Price Risk: The third important Figure4.21:VolatilityinKSE100Index source of market risk is equity price risk, VolatilityLHS KSE100IndexRHS which is primarily driven by banks 12 0.1 investments in the equity market, and 10 adverse movements in equity prices, in 0.05 8 addition to the indirect exposure from the 6 0 quantum of bank loans collateralized by 4 shares. Stepping back a bit, CY08 was an 0.05 2 eventful year for the KSE100 index which 0 0.1 touched its highest ever peak of 15,676 pointsandthenlostmorethan40percentof itsvalueoverthenextfewmonths.Thisled totheimpositionofafloorontheindexand Source:KSE whenthefloorwasliftedinDecemberCY08, the index value declined further by almost 48 percent. In comparison, the KSE100 index showedrelativestabilityinCY09andmaintainedanupwardtrendwithanincreaseof60.1 percentinitsvalue(Figure4.21). During CY09, banks investments in shares increased by Rs. 58.9 billion reflecting a 19.0 percent growth over the previous year. However as a percentage of total investments, investmentsinshareswereonly3.4percentinCY09,asagainst4.4percentinCY08.Notably, banks investments in shares is capped by SBPs prudential regulations at 20.0 percent of their respective equity.28 This drop in the share of equity investments again shows banks preference to rebalance their investment portfolio in favor of the more lucrative and risk freegovernmentsecurities.Bankwiseinformationindicatesthat18bankswithassetshare of61.3percenthavetheirinvestmentinsharesinexcessofindustryaverageof3.4percent (Figure4.22).Onaveragethesebankshold15.1percentoftheirtotalinvestmentsinshares.
millionUSDollars
The complete transfer of oil payments to the interbank market by endDecember CY09 did exert some pressure on commercialbanksNetOpenPosition.Consequently,inmostmonthsofFY10,banksmaintainednetshortpositionsinforeign currencydespitecontinuedrupeedepreciation. 27IncaseofpositiveNOP,banksactuallygainfromthedepreciationofthelocalcurrency,asthisimpliesthatforeigncurrency assetsareinexcessofforeigncurrencyliabilities. 28RegulationR6,PrudentialRegulationsforCorporate/CommercialBanking,StateBankofPakistan.
26
1Jan09 17Feb09 2Apr09 15May09 26Jun09 7Aug09 24Sep09 5Nov09 22Dec09 8Feb10 22Mar10 4May10 15Jun10 27Jul10
Jan09 Feb09 Mar09 Apr09 May09 Jun09 Jul09 Aug09 Sep09 Oct09 Nov09 Dec09 Jan10 Feb10 Mar10 Apr10 May10 Jun10 Jul10
65
The analysis indicates that the overall Figure4.22:InvestmentinShares equity exposure of the banking system is 35 considerably wellcontained as against its 30 risktakingcapacityandtheprescribedlimit 25 in prudential regulations. The sensitivity 20 analysis also indicates that an assumed 15 decline in equity prices by 30 percent and 10 50 percent, will impact the CAR of the 5 banking sector by only 11 bps and 24 bps 0 respectively. 5 0 5 10 15 4.3.3OperationalRisk marketShare Althoughoperationalriskhasalwaysbeena Source:BSD, SBP crucial component amongst the various risksthatthebankingindustryfaces,itisgainingevermoreimportanceinresponsetonew threatstofinancialstabilityasaconsequenceofastressedgeopoliticalenvironment,issues related to corporate governance and systemic vulnerabilities arising from interconnected financial markets.29 The Basel Committee on Banking Supervision (BCBS) defines operationalriskastheriskarisingfromdirectorindirectlossresultingfrominadequateor failed internal processes, people and systems or from external events, with the definition incorporatinglegalrisk.30Strategicandreputationalriskisexcludedfromthisdefinitionfor thepurposeofaminimumoperationalriskcapitalcharge.Inreviewingtheprogressofthe industry in terms of measurement of operational risk the Committee is aware that causal measurementandmodelingofoperationalriskisatanascentstage.Forthebankingsector, theCommitteehassetoutfurtherdetailsonoperationallossesintermsoflosstypesforease ofmeasurement.TheseareillustratedinTable4.10.
Table4.10:BusinessLines,LossTypesandSuggestedExposureIndicators Business Units LevelI Business Lines Lossof Recourse Legal Liability Vol.of transactions andvalueof salaries do Vol.of transactions (client liability) Vol.of corporate actions(client liability) Regulatory and Compliance (Inc. Taxation) No.of transactions do do No.of corporate actions Lossofor Damageto Assets Valueoffixed assets do do
WriteDowns
Restitution
RetailBanking Commercial Banking Banking Paymentand Settlement Agency Services
Vol.of Transactions do do
Vol.ofAssets incustody
Vol.ofAssets incustody
percentofCapital
do
do
Source:BIS
Operational risk therefore arises from complicated and diverse external and internal disruptions to business activities. The inherent unpredictability of these disruptions and theirramificationsonthebankingindustrymakeitsmeasurementandregulationdifficult.31 Operational risk mainly deals with tail events rather than structured projections or
Jobst,A.A(2007). BCBS (2001). Legal risk includes, but is not limited to, exposure to fines or punitive damages resulting from supervisory actions,aswellasprivatesettlements. 31Ibid.
29 30
66
tendencies, exhibiting uncharacteristic behavior or situations. 32 Moreover, extreme operational risk losses are usually unique oneoff events which have no historical precedents. Notably, operational risk varies considerably across banks in the industry. Incidence and scaleofinternalorexternaldisruptiontothebankingindustryiscriticallydependentonthe nature of banking activities and the sophistication of risk measurement standards and internal controls present in the bank.33 While banks normally rely on interest margins to cover potential internal or external failures, they also need to hold requisite amount of capitalreservestocoverunexpectedlosses. In the case of the domestic banking Figure4.23:CompositionofRiskWeightedAssets industry, the share of risk weighted assets in CY09 (RWA) assigned to operational risk is 13.7 percent of total riskweighted assets, and Credit Risk has registered an increase of 1.8 percent 80.5% relativetothepreviousyear(Figure4.23). Althoughthecentralbankhasaframework in place to curtail operational risk through Market Customer Due Diligence (CDD)/Know Your Risk Operation 5.8% Customer (KYC) measures, it continuously alRisk 13.7% monitorstheprogressofbanksandamends these guidelines for stricter compliance. Source:BSD,SBP Ideally efficient operational risk management hinges on several issues: (1) the judicious combination of qualitative and quantitative measures of risk estimation, (2) the robustness of these measures, given the rareincidenceofhighimpactoperationalriskeventswithout historicalprecedence,(3)the sensitivityofregulatorycapitalchargestothevariednatureofoperationalriskandreporting standardsacrossdifferentbusinessactivities.34 4.3.4LiquidityRisk Animportantlessonfromtherecentglobalfinancialcrisisforbothfinancialinstitutionsand regulators is that liquidity risk management is of paramount importance in ensuring the stability of the financial system. Since its introduction in 1988, the Basel Accord led to an inordinate focus on standardization of capital requirements for credit and market risk management, while a charge for operational risk was added on later. However matters related to liquidity risk management remained relatively neglected and intermittent episodes of excess or shortfall of liquidity, both at the overall system and individual institutions level were addressed on a casetocase basis by national regulators. The occurrence of the GFC, which was a liquidity crisis in its initial phase, prompted the Basel Committee on Banking Supervision (BCBS) to initiate work on establishing internationally acceptedstandards for liquidity adequacy.Both theBCBSandthe FinancialStabilityBoard (FSB)35areexpectedtointroduceanewsetofreformsfocusingonstrengtheningtheglobal capital and liquidity standards besides deepening and strengthening banks stress testing practicesandsupervisoryassessmentofthesepractices.
Jobst,A.A(2007). ibid. Jobst,A.A(2007). 35TheFinancialStabilityBoard(FSB)wasestablishedinApril2009asthesuccessortotheFinancialStabilityForum.FSBhas beenestablishedtocoordinateattheinternationalleveltheworkofnationalfinancialauthoritiesandinternationalstandards setting bodies and to develop and promote implementation of effective regulatory, supervisory and other financial sector policies. It brings together national authorities responsible for financial stability in significant international financial centers, international financial institutions, sectorspecific international groupings of regulators and supervisors, and committees of centralbankexperts.Source:BIS.
32 33 34
67
In the domestic regulatory framework, standardindicatorsoftheliquidityposition Figure4.24:Surplus LiquidityofBankingSector ExcessLiquidity ExcessSLR of the banking sector under the CAMELS ExcessCRR(RHS) 1000 25 supervisory framework are deemed sufficient to address elements of liquidity 750 20 risk. Notably, statutory liquidity requirements (CRR and SLR), primarily 500 15 usedasamonetarypolicytool,appeartobe 250 10 the key determinant of banks liquidity position. 0 5 250 0 In retrospect, severe but temporary liquidity strains seen in the domestic Source:SBP financial market in SeptemberOctober CY08, subsided by the end of the year on accountof SBPpolicyactionsduetowhichCY09started withrelativelyimprovedliquidity position (Figure 4.24) and less volatility in overnight rates (Figure 4.25), which in particularhasimprovedsincetheintroductionoftheinterestratecorridorfacility.
billionRupee
Figure4.25:Trends inO/NratesandLiquidityPremium Lpremium Repo Call PolicyCeiling 35 30 25 20 15 10 5 0 5 PolicyFloor
percent
Source:SBP
The overall liquidity position in CY09 can be assessed to be relatively more comfortable despitetheoccurrenceofrecurrentbutmildepisodesofliquiditystressduringtheyear.SBP changed gears on the monetary stance during the year after the prolonged period of monetary tightening since CY05, and started to gradually ease the monetary stance. The policy discount rate was reduced by 250 bps during the year. Overall liquidity position benefited from better deposit mobilization and improved foreign inflows as evidenced by higher NFA of the banking system. However factors like surge in credit demand by public sector for budgetary borrowing as well as for commodity operations, subsequent non retirementoffundsforthelatterwhichwasfurthercompoundedbyintercorporatecircular debt,werethevariouschallengeswhichcarriedimplicationsforliquiditymanagement. Quarterwise assessment of liquidity shows that despite the high demand for government budgetaryborrowingandnegligibleflowoffundstothebankingsystem(intheformofbank depositsandforeigninflows),theliquiditypositionremained comfortableinQ1CY09.This was largely due to net repayments in private sector credit 36 and continued impact of SBP policyactionstakenduringtheQ4CY08.Thisisevidencedfromthefactthat:(1)weighted average overnight repo rates remained significantly lower than the policy rate during JanuaryMarchCY09;(2)banksexcessreserveswithSBPincreasedfromRs.58billionason
36
NetrepaymentofprivatesectorcreditamountedtoRs.106.1billioninQ1CY09.
68
1Sep08 16Sep08 1Oct08 16Oct08 31Oct08 15Nov08 30Nov08 15Dec08 30Dec08 14Jan09 29Jan09 13Feb09 28Feb09 15Mar09 30Mar09 14Apr09 29Apr09 14May09 29May09 13Jun09 28Jun09 13Jul09 28Jul09 12Aug09 27Aug09 11Sep09 26Sep09 11Oct09 26Oct09 10Nov09 25Nov09 10Dec09 25Dec09
Jul08 Aug08 Oct08 Dec08 Feb09 Apr09 Jun09 Aug09 Sep09 Nov09 Jan10 Mar10 May10 Jul10
percent
October 4th, CY08 to Rs. 452 billion by March 24th, CY09; and (3) from November CY08 to MarchCY09,SBPmoppedupRs.630billion(onnetbasis)fromthemarket,inaneffortto neutralizetheimpactofexcessliquidity. Highercreditdemandfromgovernmentandsurgeinseasonalcommodityfinancingexerted liquidity pressures during Q2CY09, although factors like higher deposit mobilization, improvedforeigninflowsandnetrepaymentofprivatesectorcredit37providedsomerespite to the market. Nonetheless, the liquidity position remained tight with overnight rates remaining close to the policy rate, averaging at 12.5 percent for Q2CY09 (Figure 4.25).38 Banksexcessliquiditypositionwouldhavedeterioratedevenmorehaditnotbeenfortheir higherinvestmentsingovernmentsecurities.TheliquiditystraininQ2CY09coincidedwith stable macroeconomic conditions in the form of subsiding inflationary pressures with YoY inflation averaging at 14.9 percent for Q2CY09 relative to 20.2 percent in the previous quarter(Q1CY09).Resultantly,SBPlowereditsdiscountratetwiceby100bpseach,firstin AprilCY09and againin August CY09,39 enteringthe relatively shortlived monetary easing phase which lasted until endCY09. Disregarding the impact of some seasonal pressures duringAugustSeptemberCY09duetoRamadanandEid,monetaryeasingwasfollowedby improvedliquiditypositioninthemarketinQ3CY09. Liquidity strains reemerged and continued in Q4CY09 contributed by: (1) lower than expected retirement of loans for commodity operations, (2) persistence of the inter corporatecirculardebtproblem,(3)erraticforeigninflows(lowerNFA),and(4)netcredit offtake by the private sector on the back of improved economic activity. SBP monitored these developments closely and injected nearly Rs. 1,610.7 billion into the market in Q4 CY09.Onaccountofthedeclineininflationarypressures,SBPlowereditspolicyratefurther by 50 basis points in November CY09 with a view to support economic growth. In spite of theseactions,theliquiditystresscontinued,withovernightratesremainingconsistentlyon theuppersideoftheinterestratecorridor,touchingtheceilingratefrequently.Volatilityin overnight rates, however, was largely contained on account of the interest rate corridor (Figure4.25). Regardless of the surge in bank deposits Figure4.26:TrendsinCurrencytoDepositRatio during CY09, the currency to deposit ratio CY08 CY09 CY10 (CDR)continuedtoincreaseduringtheyear 36 exceptforadipinJuneCY09,andreacheda 34 highlevelof34.1percentinNovemberCY09 32 (Figure 4.26). Average CDR for CY09 was 30 31.2 percent, as against 29.7 percent in 28 CY08. Notably, the lower proportion of 26 monetary assets held as bank deposits 24 continue to pose challenges for banks 22 liquidity position. Given this overview of the liquidity position, the standard indicators of liquidity risk are analyzed in Source:SBP thefollowingdiscussion. Liquidityofanassetisbasedonitsabilitytobesoldwithaminimumlossofvalue.Themost widely used indicator of liquidity risk is the share of liquid assets in total assets. Banking datashowsthatthisindicatorincreasedto32.7percentbyendCY09,upfrom28.6percent
percent Feb Jun Aug Nov Mar Apr May
NetrepaymentofprivatesectorcreditamountedtoRs.78.2billioninQ2CY09. Thepolicyratewas14percentatthattime. 39SBPalsointroducedanexplicitinterestratecorridorinitsMPSdecisioninAugustCY09,inanefforttocontainthedaytoday volatilityinovernightratesbesidesmakingmonetarypolicyimplementationeffectiveandtransparent.
37 38
Dec
Sep
Oct
Jan
Jul
69
inCY08.Thisisconsistentwiththeeasingof theliquiditypositioninthebankingsectorin Figure4.27:ComponentsofLiquidAssets asShareof TotalAssets comparison with CY08. Componentwise Cash&Balances Governmentsecurities BalancesWithOtherBanks Interbanklending analysis suggests that this rise in liquid 50 assets mainly emanates from the rise in investments in government securities, with 40 only a marginal growth in loans (Figure 30 4.27). 20 Distribution of banks on the basis of the 10 liquid assets to total assets ratio reveals a 0 similar improvement in the overall liquidity CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY09 positionofthebankingindustry.Specifically, Source:BSD,SBP thenumberofbanksbelowtheindustry average declined to 16 from 20 in CY08 Table4.11:DistributionofBanksbyLiquidtoTotalAsset (Table 4.11). Also, 1 bank (against 2 in No.ofbanks CY08)hadthisratiobelow10percentwhile CY06 CY07 CY08 CY09 4 banks (against 3 in CY08) had a ratio Lessthan10 1 0 2 1 ranging between 10 and 20 percent. This from10to20 2 1 3 4 suggests that some small banks are still <Industryaverage 19 16 20 16 facing liquiditystressdespite improvements IndustryAverage(%) 32.0 33.6 28.2 32.7 intheoverallliquidityposition. Source:BSD,SBP Anotherimportantindicatorofliquidityrisk, Figure4.28:Advances(NetofEFS)toDeposit the advances to deposits ratio (ADR) also Ratio(ADR) improved in CY09 and declined to 63.3 75 percent from 71.3 percent in CY08 (Figure 70 4.28). Both the relatively strong growth in 65 depositsaswellasthesubstantialslowdown 60 in loans disbursed during the year 55 contributed to the improved ADR (net of 50 EFS) ratio during CY09. While an indication 45 ofimprovedliquidity,thedeclineinADRalso 40 points to both to the tightening of credit by banks, with their focus shifting towards investments,andtothesubdueddemandfor Source:BSD, SBP creditfromtheprivatesector. Table4.12:DistributionofBanksbyAdvancestoDeposit Ratio Thedistributionofbanksonthebasisofthe No.ofbanks ADR suggests that only 1 bank has its ADR CY06 CY07 CY08 CY09 above 100 percent while for 4 banks this >100 2 2 3 1 ratio ranges between 80 and 100 percent, b/w80to100 2 3 4 4 withthenumberofbanksbelowthemarket >Industryaverage 14 13 13 13 70.3 66.8 71.3 63.4 averageremainingthesameasinCY08,at13 IndustryAverage(%) Source:BSD,SBP (Table4.12). The analysis of the maturity gap presents another dimension for assessing banks liquidity position.DuringCY09,thegapbetweenassetsandliabilitiesindifferenttimebuckets(except forassetsandliabilitiesof1yearto5yearmaturity)increased,andforshorttenorsofupto 3months,and3monthsto1year,thegapbreachedtheconventionallyacceptedrangeof
percent
percent
CY00
CY01
CY02
CY03
CY04
CY05
CY06
CY07
CY08
70
CY09
10.0percentoftotalassets(Figure4.29).40
On the face of it, this suggests a CY09 CY08 deterioration in the maturity mismatch profile in CY09. However, such an Over5yrs assessment needs to be viewed in the context of the increasing share of 1yrto5yrs investments in banks total assets. While 3mto1yr longer tenor investments can result in increasing the gap between assets and Upto3m liabilities, these investments are in liquid governmentsecuritiesforwhichthereisan 20 10 0 10 active secondary market and market aspercentofAssets participants have access to an exit Source:BSD, SBP mechanism, which actually bodes well for theassetliabilitymaturityprofileofbanks. Notwithstanding, the classification of Figure4.30:ShareofFixedDepositsinTotalDeposits deposits indicates that the share of fixed 40 deposits in total deposits has declined to 35 32.9percentinCY09asagainst34.8percent 30 inCY08(Figure4.30),suchthatthegrowth 25 in fixed deposits decelerated from 26.3 20 percentinCY08to7.1percentinCY09.This 15 considerable slowdown in growth in fixed 10 deposits is despite the exemption of time 5 liabilities (including time deposits with 0 tenor of 1 year and above) from SLR 41 Not surprisingly however, requirements. share of fixed deposits of more than 1 year Source:BSD, SBP in overall fixed deposits has increased, suggestingthatthedipintheshareoffixeddepositsisonaccountofthedeclineintheshare ofdepositsoflessthan1year.Asmentionedearlier,inadeclininginterestrateenvironment banksconcentratedonmobilizinglowcostdeposits(currentaccount/savingsaccount)as opposedtothemoreexpensivefixeddeposits. In sum, the analysis of liquidity risk from various dimensions indicates that the overall liquidity risk profile of the banking system improved during CY09. However small banks continue to face liquidity strains as evidenced by their low level of liquid assets to total assetsratioinconjunctionwiththeirhighadvancestodepositratio.Althoughnoneofthese banksissystemicallyimportant,andeventheir42aggregatemarketshareisonly2.0percent, their inability to overcome the persistent liquidity problems can have significant implicationsbyunderminingperceptionsandthelevelofconfidenceinthebankingsector. 4.4RiskAbsorptionCapacityoftheBankingSystem With a continually evolving risk profile of the banking sector, systemic stability crucially dependsontheriskbearingcapacityofindividualinstitutionsintheindustry.Banksability to absorb risks is determined by their profitability and sustained by their capital position. Profits retained in the form of reserves and fully paidup capital provide the first line of defense,actingasbuffersagainstnegativeshocks.Besidestheprimaryfunctionofabsorbing losses emanating from banking operations, profitability also serves to build a financial
40 This gap is mainly attributed to banks tendency to place demand deposits (the noncontractual liabilities which have a significantshareintotalliabilities)inthisbucket. 41CRRontimeliabilitieswasabolishedonAugust10,CY07,andSLRwasremovedonOctober24,CY08. 42Theseincludetwospecializedbanks.
Figure4.29:MaturityGap(AssetsLiabilities)
CY09
71
institutionscapitalbase.Intermsofpeckingorder43behavior,thesupplementarybenefitof buildingahealthycapitalpositionisthatitenablesaccesstocheapinternalresourcestofund business operations. Capital then serves as the cushion available with banks to absorb unexpectedlosses. Giventheimportanceofprofitabilityandcapitaladequacyintheanalysisoftheriskprofileof thebankingsector,thefollowingsectionsprovideadetailedanalysisoftheseindicators. 4.4.1Profitability Profitability is imperative for the smooth functioning of the banking sector, serving as a cushion to absorb losses emanating from banks operations. Profitability of the banking system posted a gain of 27.6 percent in CY09, with a (before tax) profit of Rs 80.7 billion. Overall, both ROA and ROE increased during CY09, a trend in contrast to the consistent declineintheseratiossinceCY06.
Table4.13:ProfitabilityoftheBankingSector billionRupees ProfitBeforeTax ProfitAfterTax No.ofbanksinloss Source:BSD,SBP CY00 4.5 2.8 10 CY01 1.1 9.8 12 CY02 19.0 2.9 6 CY03 43.8 24.7 8 CY04 52.1 34.7 5 CY05 93.8 63.3 7 CY06 120.8 81.9 7 CY07 106.9 73.1 10 CY08 63.2 43.3 16 CY09 80.7 54.4 18
Table 4.13 gives details of banks profitability position over the decade. In line with the increaseintheprofitbeforetax,profitaftertaxofthebankingsectoralsopostedagrowthof 25.7percentduringCY09,increasingtoRs54.4billion.Bankwiseinformationofprofitafter taxrevealsthat18banks,withacumulativeshareof12.7percentinassets,recordedlosses duringCY09. Theseincludeonemidsizedand17smallsizedbanks, wherethecumulative market share of the latter is only 8.8 percent. However, the top 10 banks, with a market share of 73 percent, posted profits of Rs 70.6 billion in CY09, exhibiting a growth of 11.8 percentoverthepreviousyear(Table4.14).Thisindicatesthatbankingsectorprofitability isdominatedbythetopplayersintheindustry.
Table4.14:DistributionofBanksbyROA ROA 0&below B/W0to0.5 B/W0.5to1.0 1.0&above Source:BSD,SBP CY07 No.ofBanks 10 3 3 23 %shareinTA 8.5 2.8 1.5 87.2 CY08 No.ofBanks 16 7 5 12 %shareinTA 14.5 16.5 7.4 61.6 CY09 No.ofBanks 18 7 5 10 %shareinTA 12.7 20.8 6.1 60.4
ROA for the overall banking system was 0.9 percent for CY09. Eleven banks with a cumulativemarketshareof62.3percentrecordedanaboveaverageperformanceintermsof thisprofitabilityindicatorinCY09.Theseinclude2specializedbanks,1publicsectorbank, and 8 local private banks. Figure 4.31 shows banks with ROA above the overall industry level of 0.9 percent, with size of the bubbles reflecting individual banks market share. As evidentfromthegraph,bankswiththehighestROAaresmallsizedbanks,reflectingthefact that not all small sized banks are in trouble.44 Notably during CY09 the increase in profitabilityasindicatedbyROAisincontrasttothefallingtrendsinceCY06.
PeckingOrdertheorypostulatesthattofinancefirmprojects,internalresourcesarepreferredoverexternalfunds,thendebt isissuedandfinallyequitybaseisenhancedifmorefundsarerequired.DetailsinMyersandMajluf(1984). 44ThebankwiththehighestROAhasamarketshareof0.2percent.
43
72
Data on conventional sources of banks Figure4.31:BanksWithAboveAverageROA incomenetinterestincome(NII)andnon interest income shows that NII grew by 5 11.5 percent in CY09, relatively lower than 4 the growth of 17.8 percent in the previous year.Ontheotherhand,noninterestincome 3 increased marginally by 0.8 percent, compared to an increase of 6.8 percent in 2 CY08. However, the major reason for the 1 improved profitability position in CY09 comes from a significant reduction in 0 provisioning expenses.45 Provisioning 0 5 10 15 expense benefited from the amendments in No.ofbanks Source:BSD,SBP prudential regulations on availing the benefit of Forced Sale Value (FSV) on collateral. This benefit had been completely Table4.15:BenefitofFSVavailedinProvisioning withdrawn in CY07,46 however revised billionRupees guidelines issued in January CY09 allowed CY08 CY09 YoYGrowth(%) bankstoavail30percentoftheFSVbenefit, AllBanks 9.3 21.7 134.4 which was subsequently increased to 40 PSCB 2.7 0.6 (76.8) percent in October CY09. Even though the LPB 6.4 20.4 217.1 circular issued in January CY09 allowed FB 0.1 0.6 278.8 banks to avail the FSV benefit w.e.f. SB 0.0 0.1 31.12.2008, banks were generally unable to Source:SBPCalculations offset the concession against their provisioning expenses for the year, as they were already in the process of closing annual accounts for CY08. Hence they were able to fully utilize this benefit when making provisioning expenses for CY09. Table 4.15 shows that the FSV benefit was used more pronouncedly by domestic private banks and foreign banks.47 In addition, prudential regulations were also amended to allow banks to upgrade a nonperforming loan by one categoryincaseofitssuccessfulrestructuring. 48 Figure 4.32 shows that interest income Figure4.32:SourcesofGrossIncome InterestIncome which has a share of 85.5 percent in total Fees,Commission&BrokerageIncome income at endCY09, increased by almost DividendIncome IncomeFromDealingInForeignCurrencies 2.6 percentage points over the previous OtherIncome year. During CY09 interest income earned 100 on customers loans increased by 22.1 80 percent,asagainst26.3percentinCY08.On 60 the other hand, noninterest income which 86 85 84 83 82 82 80 40 80 71 69 consists of: (1) fees, commission and 20 brokerageincome,(2)dividendincomeand 0 (3) income from dealing in foreign currencies,increasedonlymarginallyby0.8 percent. In particular, the depreciation of Source:BSD, SBP 6.1 percent in the rupeedollar parity contributedtothe17.1percentdeclineinincomeearnedfromtradinginforeigncurrencies.
percent
ROAinpercent
CY00
CY01
CY02
CY03
CY04
CY05
CY06
CY07
CY08
Amendmentswereintroducedinthecalculationofprovisioning whichallowedbankstoavail40percentbenefit ofForced Sale Value (FSV) of collateral as opposed to the previous concession of 30 percent, as detailed in BSD Circular No. 02 dated January27,2009andBSDCircularNo.10,datedOctober20,2009. 46BSDCircularNo.7datedOctober12,2007. 47 The biggest entity among PSCBs is National Bank. Given that a large proportion of its loans are backed by property as collateral,itdoesnotfinditfeasibletoconductexpensivevaluationsdoneinordertoavailtheFSVbenefit. 48BSDCircularNo.10datedOctober20,2009.
45
CY09
73
Fees, Commission and Brokerage Income, one of the major components of noninterest income,increasedbyonly3.6percent,relativeto14.0percentinCY08. An assessment of the change in the nature Figure4.33:NIMandAverageSpread and quantum of earning assets provides ReturnonEA CostofFunds NIM useful information in analyzing banks 14 profitability. During CY09, earning assets 12 primarilyincreasedonaccountofgrowthin 10 investments (Figure 4.33). Bankwise 8 increaseinearningassetsgivescredenceto 6 this trend; foreign banks exhibited the 4 highest increase in earning assets which 2 correspondswiththesignificantincreasein 0 their investments during the year. The key contribution to banks profits comes from the net interest margin (NIM), a performance metric which measures the Source:BSD, SBP realizedprofitpositionofbanksrelativetotheirpotentialearningassets.TheNIMinCY09 was 5.25 percent, just 4 bps less than 5.29 percent in CY08. Further analysis of the componentsof NIM revealsthat althoughthespreadbetweenthe returnonearningassets and cost of funds showed slight improvement, the increase in earning assets was greater. Factors responsible for the marginal decline in NIM include monetary easing throughout CY09,leadingtoadeclineininterestrates.Thisisalsoreflectedfromthefactthatweighted averagelendingratespeakedinJanuaryCY09atanalltimehighof14.7percent,thereafter decliningby117bpsinCY09.Thedeclineinlendingrateshadtheeffectofslowingdownthe interestearningsonadvancesasevidentfromdecelerationinitsgrowthfrom32.8percent in CY08 to 14.8 percent in CY09. In addition to the decline in lending rates, the continued minimumfloorof5percentonthereturnonsavingdepositsalsoputfurtherpressureonthe NIM. Given the declining interest rate environment, although banks interest income increased, growth rate of interest income declined by 4 percent in CY09. However, banks earned a substantial amount in the revaluation of assets, augmenting their existing pool of income. Dissecting the increase in interest income Table4.16:SourcesofChangeinInterestIncomeon through changes in rate and changes in Customers'LoansandInterestExpenseonDeposits Balanceof Change Change volume reveals that its growth during CY09 the Dueto Dueto was primarily driven by a variation in loan Billion Previous Rate Volume Balancefor volumecontributing63.6percenttothetotal Rupees Year Variation Variance theyear increase in interest income (Table 4.16). InterestincomeonCustomers'Loans Thisisincontrasttothepreviousyearwhere CY04 67 11.6 21.6 77 the increase in interest income was CY05 77 46.7 25.4 149 attributed to a rate variation. As mentioned CY06 149.1 37.5 35.7 222.2 above, monetary easing led to a decline in CY07 222.2 8.4 35.1 265.7 lending rates, which suppressed banks CY08 265.7 48.6 38.7 353.1 abilitytoincreaseinterestincomethrougha CY09 353.0 19.1 33.2 405.3 variationinrate.Ontheotherhand,variance InterestExpenseonDeposits analysis of noninterest income reveals that CY04 33.4 11.7 6.5 28.2 the change seen in CY09 was driven by a CY05 28.2 26.2 5.6 59.9 change in charges and commissions rather CY06 59.9 40.1 9.9 110 than change in volume of transactions. With CY07 110 24.1 17.5 151.6 slowgrowthinadvances,banksmadeefforts CY08 151.6 33.1 21.8 206.5 tocompensatefordeteriorationinincomeby CY09 206.4 43.6 23.8 273.8 increasing charges on sources comprising Source:BSD,SBP noninterestincome.
74
CY09
On the other hand, decomposing the increase in interest expense into volumetric and rate changesrevealsthattheincreaseininterestexpenseondepositswasprimarilydrivenbythe variation in deposit rates. Almost 64.7 percent of the increase in interest expense was contributed by deposit rates, compared to 62.6 percent in CY08. Consolidated data for the bankingsectorrevealsthatthecostofincrementaldepositsincreasedby1percentagepoint overtheyear,resultingintheincreaseininterestexpenseby32.6percentinCY09. In sum, the overall profitability of banking system improved in CY09 in comparison to the previousyear.Bankwiseinformationindicatesthatfewerbankscontributedtothegrowth in profits, with a large number of smallsized banks still constrained from achieving a profitable position. The profitability position of banks was however aided by the gradual recovery in the macroeconomic environment and monetary easing throughout the year, resultinginsignificantgainsintermsofrevaluationofsecurities.Withrisingnonperforming loans and associated increase in provisioning expenses, in addition to the reversal in the monetary stance in CY10, maintaining this profitability position might be challenging in comingyears. 4.4.2SolvencyandCapitalAdequacy Among other initiatives to strengthen the traditional banking business model, guidelines issuedbytheBCBSparticularlyfocusoncapitaladequacystandardsinrecognitionofthefact that capital works as a central buffer to absorb losses emanating from operational and financialactivitiesofabank.Boththelevelandthecompositionofcapital(intermsofcore and supplementary capital) demonstrate the capacity of an individual institution to withstand potential threats to its financial viability. An adequately capitalized bank earns strongratingsand isbetter able to protect stakeholdersinterestin thefaceof unexpected events.SBPhasbeenfullycognizantoftheimportanceofenhancingbankscapitalbaseand theirsolvencyposition,andhasprescribedaphasedplan 49forbankstoincreasetheirpaid upcapital(freeoflosses)toRs.10billionbytheendof2013.Thissectionprovidesadetailed assessmentonthevariousmeasuresofcapitaladequacyandsolvencyofbanks. Table4.17:CategorywisePositionofBanksEquity During CY09, banks overall equity base billionRupees %Share %YoY increasedby17.3percent(YoY)toRs.660.3 Equity CY08 CY09 inTotal Growth billion (Table 4.17). Local private banks, PSCB 112.0 139.2 21.1 24.3 with a share of 73.9 percent in total equity, LPB 421.2 487.7 73.9 15.8 were the main contributors to this growth. Foreign 34.0 35.7 5.4 5.2 The increase in equity base during CY09 SB 4.2 2.4 0.4 41.8 resulted largely from: (1) FSV benefit which All 563.0 660.3 100 17.3 limitedtheprovisioningcharge,(2)increase Source:BSD,SBP in unappropriated profits by 25.6 percent, and(3)asubstantialincreaseinthesurplus Figure4.34:TrendsinBankingCapital Corecapital SupplementaryCapital on revaluation of assets. Corresponding 700 changes are also visible in the qualifying 600 capital (net of losses) for the MCR. At end 500 CY09, 23 banks were fully compliant with MCRwhiletheremainingareintheprocess 400 of increasing their capital base by injecting 300 fresh capital or through mergers and 200 acquisitionswithintheindustry. 100 0 Figure 4.34 shows corresponding changes in total capital (net of losses), which Source:BSD, SBP increasedbyRs.100.3billioncomparedto
billionRupees CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08
49
BSDCircularNo.7datedApril15,2009.
CY09
75
Rs. 38.8 billion in CY08. This growth of 19.8 percent in capital is contributed by its two components 82.5 percent by core capital and 17.5 percent by supplementary capital, the two components of regulatory capital. Adjusting core capital for goodwill, shortfall in provisions, etc. main components of core capital are paidup capital, balance in share premium account, reserves (general and for issue of bonus shares), unappropriated profit/loss, and minority interest. Core capital is the main anchor against risk to the survivability of an institution and its importance can be measured in terms of the recent enhancements in the Basel II (commonly known as Basel III) which emphasizes further refining/haircutsonthecorecapitalandencouragesincreasingitsshareintotalcapital. TierIdatashowsthat30outoftotal40scheduledbankshave increasedtheircorecapital whereasremaining10banks(with7.1percentshareintotalassetsofthebankingsystem) haveregistereddeclineincorecapital.Onnetbasis,corecapitalincreasedbyRs.77.8billion (18.7percentincreaseoverthepreviousyear)forthewholeindustry.Itisinterestingtonote that64.2percentofthatincreaseincorecapitalcomesfromthebig5banks. In addition to the absolute amount of the Figure4.35:CAR&RWA MCR, banks are also required to maintain RWAtoTotalAssets CAR capital according to their riskweighted TierIcapitaltoRWA assets(RWA).TheminimumcapitaltoRWA 80 16 ratio(CAR)for endCY09was10.0percent. 70 14 60 12 Prior to going into details regarding the 50 10 distribution of CAR across the banking 40 8 sector, some details of RWA will help in 30 6 understanding banks risk bearing capacity. 20 4 The consolidated balance sheet of the 10 2 0 0 banking sector at endCY09 shows that banks held Rs. 4,262.5 billion as RWA, whichis4.4percenthigherthantheamount Source:BSD,SBP heldinCY08.Notably,thisgrowthinRWAis much less than the 15.8 percent growth in Figure4.36:CARofBanksandMarketShares overall banking assets. The reason for this CAR MinCAR slowgrowthinRWAisclearlyvisibleinthe 100 increasedexposureofthebankingsectorto 80 thegovernment,bothintheformofloansto 60 PSEs and the federal government for 40 commodity operations, and the substantial 20 increase in investments in government 0 securities, both of which carry low risk 0 5 10 15 weights. These shifts have had a positive MarketShare impactonriskweightedCARunderBaselII, Note:Threebankshavebeenexcluded,oneisspecialized bankwith negativeCARandothertwoarecommercialbankwithhasexceptionally raisingitfrom12.3percentinCY08to14.0 highratio,with9.7and33.5standarddevitionfrommeanvalueof19.5 percent. percent in CY09 (Figure 4.35). Consistent Source:BSD,SBP with this development, the ratio of core capitaltoRWAalsoinchedupfrom10.2to11.6percentinCY09. Bankwise information on CAR indicates that 34 out of 40 banks (with a share of 93.6 percentintotalassets)havetheirrespectiveCARabovetherequiredratioof10percentfor CY09.Theremaining6bankswhicharebelowtheminimumrequiredratioinclude2public sectorbanks,1specializedbankand3localprivatebanks. Figure4.36showsthattherewere6bankswithamarketshareofmorethan5percenton individual basis with average CAR of 15.1 percent. Improvement in capital adequacy may
76
CARinpercent
CY09
percent
alsobejudgedfromthefactthatassetshare Figure4.37:AssetShareofBankswithCARAbove10% of banks meeting minimum requirement of 10 percent CAR has increased to 93.4 100 percentinCY09from56.3percentinCY08 90 (Figure4.37). 80 70 4.4.3ResilienceoftheBankingSector Theanalysisoftheriskprofileandtherisk 60 bearing capacity of the banking industry 50 indicates that while the risk profile 40 improved marginally, banks riskbearing capacity showed encouraging progress in terms of total equity in CY09. This section Source:BSD,SBP examines the resilience of the banking system by assessing the impact of the potential threat of deterioration in asset Figure4.38:NetNPLstoCapitalRatio quality in terms of banks capital base and 60 singlefactor stresstesting or sensitivity 50 analysis. 40 TheamountofnetNPLs(NPLsadjustedfor 30 provisions) is a key indicator in measuring 20 the potential risks to banks solvency position. Banks net NPLs surged to Rs 147 10 billioninCY09,againstRs121billioninthe 0 previous year, an increase of 21.5 percent on YoY basis. Relative to 19.4 percent in CY08, the net NPLs to capital ratio Source:BSD, SBP deteriorated to 22.3 percent by endCY09 (Figure4.38).IftheamountofnetNPLsis Figure4.39:DistributionofNetNPLstoCapitalRatio written off directly against banks capital CY07 CY08 CY09 base, then the overall CAR declines to 10.6 25 percent, still higher than the required level 20 of 10.0 percent. However, while the threat tothecapitalbaseinaggregateseemstobe 15 in manageable limits, a similar conclusion 10 can probably not be derived for individual banks. 5 0 BankwiseinformationrevealsthatinCY09, only3banks(asopposedto7inCY08),with a share of 4.2 percent in total assets, have registered an overall negative ratio. Source:BSD,SBP Moreover,20bankswith70percentshareintotalassets,postedanetNPLtocapitalratioin therangeof0to20percent,i.e.lessthantheindustryaverage(22.3percent)(Figure4.39). ItisexpectedthatthesebankscanreasonablymanagethepotentialimpactofthenetNPLs ontheirrespectivecapitalbase.SimilartoCY08however,2banksratioisover100percent, one being a mediumsized bank and the other a small bank. Although these banks do not pose any systemic risk, they need to be closely monitored. Further details show that there are 5 banks with net NPLs to capital ratio in the range of 60 to 80 percent, however their shareintotalassetsofthebankingindustryisonly2.7percent.Allthisinformationsuggests thatafewsmallsizedbankswithasmallmarketshareintheindustryarefacingthethreatof erosion of their capital base, however banks with a dominant share in the sector have the capacitytoabsorblossemanatingfromafurtherdeteriorationinassetquality.
percent
CY03
CY04
CY05
CY06
CY07
CY08
percent
80100
020
2040
4060
6080
<100
CY09
CY09
77
Another method to test the resilience of the banking sector is based on the singlefactor sensitivityanalysis,50conductedforthreemajorriskfactorsi.e.creditrisk,marketriskand liquidity risk.51 The magnitude of change (or shock in terms of the stress testing methodology)intheriskfactorsisdrivenbythehistoricalvolatilityineachvariableandan analysis of future movement based on hypothetical scenarios. Specific shocks used in the analysis are summarized in Table 4.18. In order to calibrate the realistic impact of these shocks,changeinprofitshasbeentaxadjustedwhilecalculatingtheaftershocklevelofthe capital adequacy ratio (CAR) based on the Basel II framework. Under each scenario, after shockCARiscomparedwiththeminimumrequiredCARof10percentatendCY09toassess banksresiliencetowardsspecificshocks.Notably,thisprocessemploysanumberofexplicit andimplicitassumptions.
Table4.18:ShockstoRiskFactorsandImpactonCARbasedondataforendDecemberCY09 Shocks CreditRisk C1:15%ofperformingloansmovingtosubstandard,15%ofsubstandardto doubtful,25%ofdoubtfultoloss. C2:Tighteningofloanclassificationi.e.allNPLsunderOAEMrequire25% provisioning,allNPLsundersubstandardrequire50%andallNPLsindoubtful categoryrequire100%provisioning. C3:25%ofloanstothetextilesectordirectlydowngradedtodoubtfulcategory C4:25%ofconsumerloans(autoloans,personalloans&consumerdurablesonly) classifiedintodoubtfulcategory. C5:CriticalInfectionRatio(TheratioofNPLstoLoanswherecapitaliswipedout) MarketRisk:InterestRateRisk IR1:Anincreaseininterestratesby200basispoints. IR2:Anincreaseininterestratesby300basispoints. IR3:Anincreaseininterestratesby400basispoints. IR4:Anincreaseininterestratesby500basispoints. IR5:Shiftcoupledwithflatteningoftheyieldcurvebyincreasing500,300and200 basispointsinthethreematuritiesrespectively. MarketRisk:ExchangeRateRisk ER1:DepreciationofExchangeRateby25%. ER1:AppreciationofExchangeRateby5%. MarketRisk:EquityPriceRisk EQ1:Fallintheequitypricesby30%. EQ2:Fallintheequitypricesby50%. CombinedMarket&CreditShocks COMB1:Interestratesincrease(2%),deteriorationofloanstothetextilesector (25%)directlydowngradedtodoubtfulcategory,andfallinequitypricesby30%. COMB2:Deteriorationinloanportfolio(performingtosubstandard:15%, substandardtodoubtful:15%,doubtfultoloss:20%),fallintheequityprices(50%). LiquidityRisk* L1:Withdrawalofcustomerdepositsby2%,5%,10%,10%and10%forfive consecutivedaysrespectively. *:No.ofIlliquidbankson4thand5thdays Source:SBPCalculations (0.11) (0.24) (1.46) (1.86) 14.01 13.88 12.66 12.26 0.58 (0.12) 14.70 14.00 (1.61) (1.70) (0.81) (0.28) (14.12) (0.53) (0.79) (1.06) (1.33) (0.58) 12.51 12.42 13.31 13.84 13.59 13.33 13.06 12.79 13.54 ImpactonCAR AfterShock CAR
No.ofIlliquidBanks 2 5

50InformationusedinthissectionisprovidedbytheBankingSurveillanceDepartment.Theresultsarebasedontheunaudited quarterlydataforendDecemberCY08. 51Theseresults,asofanystresstestexercise,arenotforecastsofexpectedoutcomes,sincethescenarioshavebeendesignedas "whatif"situationsunderplausiblebutextremeassumptions.
78
Theresultssuggestthatcreditriskisthemostdominantriskfactorintermsofitsimpacton CAR. Amongst the credit shocks, C1 is the most rigorous, causing the overall CAR of the banking sector to decline to 12.42 percent. While the overall postshock CAR is above the minimumrequiredbenchmarkof10percent,3banksinadditiontothe6bankswhoseCAR isalreadybelowtherequiredlevel,wouldexperiencedeteriorationintheirrespectiveCARs incaseofsuchascenario. Credit concentration in textile sector could possibly be another concern for the stability of thebankingsectorwithitsshareof19.9percentintotalloanportfolioofbankingindustry. Deteriorationinthequalityofloanstothetextilesectoralonecanhaveasignificantimpact onbanksCAR,asimpliedbytheassumptionofdeteriorationinthequalityof25percentof these loans in which case the CAR would decline to 13.31 percent. With a provisioning requirement of 50 percent under the NPLs doubtful category, the impact of this shock is relativelysubduedasnoneoftheindividualbanksCARisimpactedwiththeapplicationof thisshock. TheCriticalinfectionratio,whichisthestressedNPLtoloansratioresultinginacomplete erosionofcapitalofthebankingsystem,is29.8percentasagainstthepresentlevelofactual NPLtoloansratioat12.9percent.Thissuggeststhatthedeteriorationinthequalityofthe creditportfolioneedstotwiceasbadasitspresentlevelto wipeouttheequityofbanking system. The Banking sector is fairly resilient towards various market risk shocks (interest rate, exchange rate and equity price movements). CAR of none of the banks would be impacted under the market risk shocks except for the 6 banks with their preshock CARs already below10percent. Thecombinedapplicationofcreditandmarketshock(COMB2)whichassumes15percent of performing loans deteriorate to substandard, 15 percent of substandard to doubtful, 25 percent of doubtful to loss, in addition to a decline in equity prices by 50 percent, is the biggestshockofthisexercise.Underthisshock,theoverallCARdeclinesby210bpsto11.9 percent. In order to assess the resilience of banks towards liquidity risk, a shock of deposits withdrawal by 2, 5, 10, 10 and 10 percent successively for five consecutive days has a substantial impact on the banking sector. Results of this shock indicate that all banks can withstand this shock for 3 consecutive days, subsequent to which on day 4, 3 midsized bankswouldneedtoforceselltheirnonliquidassetstohonourtheassumedwithdrawals. Further, on day5, one more bank from the big 5 group would have to sell its nonliquid assetstohonourtheassumeddepositwithdrawal. ThustheresultsofsensitivityexercisefordataatendCY10suggeststhatthestrongsolvency profile of the banking system provides sufficient cushion to absorb losses in case of any significantadversemovementsinthecredit,liquidityandmarketriskfactors. 4.5Conclusion SubsequenttothequagmireofchallengesfacedbythebankingsectorinCY08,CY09wasa year of risk consolidation for the banking sector, with a marked rebalancing of its asset portfoliofromadvancestoinvestments.Bankseffortstocontaintheelementofcreditrisk wereclearlyvisible fromboth: (1)theirinclination toinvest in government securities,and (2)theirpreferencetomeetthefinancingneedsofthegovernmentratherthantheprivate sector,fromwhomthedemandforcreditalsoremainedsubduedgiventhegeneraleconomic slowdown.
79
Thegrowthofnonperformingloans,akeycreditriskindictor,showeddeceleration,andthe emphasis on investments rather than expansion of the loan book, is expected to have a positive carryover impact on provisioning expense in CY10. While SBPs monetary easing stanceduringCY09hadabeneficialimpactonmarketriskelements,areversalinthepolicy stance subsequently carries implications for both market risk and credit risk, as higher interestratesimpingeonborrowersrepaymentcapacity. Notably,profitabilityofthebankingsectorinCY09wasskewedtowardsthetop10players ratherthansharedacrosstheindustry.Thisisanindicationofthecontinuedstrainsfacedby somemediumsizedandmostofthesmallbanks,particularlygivenhighloanlossprovisions whichhaveimpactedtheirearnings,andconsequentlytheircapitalbase,makingitdifficult forthemtocomplywithminimumcapitalrequirements. Sensitivityanalysisbasedonsinglefactorstresstestingexerciseshowthatbankingsectoris wellcapitalizedtowithstandvarietyofshockswithrespecttocreditandmarketriskaswell ascombinationsofthetwo.Bankwiseinformationindicatesthatexceptafewsmall banks which continue to face problems, individual institutions have further built up there risk absorption capacity and they are expected to cope with any potential deterioration in risk factors.
80
DevelopmentsintheBankingSectorinH1CY10ABriefReview52 While CY08 was a challenging year for the banking sector when adverse developments in variousriskfactorsseverelytesteditsresilience,CY09wasayearofriskconsolidation,with amarkedshiftinassetallocationfromloanstoinvestments,andavisibleslowdowninthe previously rapid process of deterioration of asset quality. The gradual process of macroeconomic recovery in CY09, no matter how tenuous, helped the banking sector in reassessingitsapproachtowardsimprovingitscreditriskprofile. Continuing further into the first half of CY10, the process of macroeconomic recovery/stabilizationwasmarredbytheresurgenceininflationarypressures,fromasearly as January CY10, when CPI inflation increased to 13.7 percent, from 10.5 percent in DecemberCY09,andcontinuedtohoveraroundthisleveluntilJuneCY10whenitdeclinedto 12.7 percent. With an eye on the gradually recovering economic growth, SBP decided to adoptamorecautiousstanceandkeptthepolicydiscountrate unchangedinthemonetary policy statement / decisions in January, March and May CY10. The reversal in the policy stance, from easing to tightening, was then put into place explicitly in July CY10, when the discount rate was increased by 50 bps to 13.0 percent, and then again by 50 bps in SeptemberCY10. Inthemidstofthisparticularoperatingenvironment,banksweregenerallyabletosustain themodestprogressintheirprofitability,solvencyandotherperformanceindicatorsinH1 CY10.Exceptforafewsmallbankswhichcontinuetofacedifficultiesintheirrisktakingand riskabsorptioncapacity,theoverallbankingsystemcontinuedtodemonstrateitsresilience tothefrequentlychangingoperatingenvironmentandassociatedrisks. The composition of the asset base in CY09, with incremental assets skewed towards investmentsratherthanloans,remainedthesameduringthefirsthalfof2010.Thelagged impactofvariousadversefactorscontinuedtotesttherepaymentcapacityoftheborrowers and served to increase banks riskaverse posture. Growth in incremental NPLs had decelerated substantially in CY09. In H1CY10 also, the overall risks to advances portfolio showedsomerespite,withgrowthinNPLsat6.4percent.Nonetheless,agingofthealready classified loan portfolio from partially provided to fully provided loss category led to additionalprovisioningrequirements. Inthisbackdrop,thefinancialperformanceofthebankingsectorduringH1CY10isbriefly reviewedinthissection. Havinggrownby15.8percentinCY09,banksassetbaseincreasedbyamere3.9percentin H1CY10. Quarterly data shows that this growth was largely concentrated in the second quarterofCY10.Assetsactuallycontractedby1.5percentduringQ1CY10,howevergrowth of5.4percentinQ2CY10offsetthateffect.Furtherdetailondifferentcomponentsofassets shows that the contraction in assets was driven by net retirement in advances and decelerationininvestmentgrowth. Asmentionedintheintroductiontothisreview,thepatternofassetcomposition,asshaped inCY09,persistedinH1CY10andbankscontinuedtoholdgrowingshareofinvestmentsin their asset portfolio. However, when compared to the 30.2 percent growth in H1CY09, growth in investments decelerated to 8.0 percent in H1CY10. The loan portfolio, on the other hand, showed net retirement of 0.5 percent during H1CY10, and its share in assets dippedfrom49.7percentbyendCY09to47.6percentbyendH1CY10.
52
DetailedanalysiscanbeseenintheQuarterlyPerformanceReviewoftheBankingSystemforquarterendedMarchandJune 2010,BankingSurveillanceDepartment,StateBankofPakistan.
81
DetailsonbanksadvancesportfolioshowsthatduringQ1CY10commodityfinance,mainly obtained for wheat and cotton, was retired by 13.0 percent. However, in Q2CY10 it expandedby33.0percent.Themarginaldeclineingrowthofadvanceswasreflectedinthe fall in outstanding advances to major segments including corporate, SMEs, agriculture and consumer finance. In contrast to these retirements, government continued to be the dominant user of bank credit and its share in total loans grew to 18.4 percent by end H1 CY10,from17.4percentatendCY09.Thenetimpactofthecontinuedchangeinassetmixis thattheprivatesector,theengineofgrowthintheeconomy,islosingitsshareintotalbank credit. Table4.19:KeyFinancialIndicators Breakdown of banks funding base shows percent H1 H1 thattheexpansioninassetsinthefirsthalfof CY08 CY09 CY09 CY10 2010 was mainly funded by growth in GrowthofAssets 8.8 7.7 15.8 3.9 deposits, which grew by 7.1 percent during InvestmentsGrowth 14.8 30.2 59.9 8.0 in H1CY10.53 However, this increase was AdvancesGrowth 18.0 0.8 2.1 0.5 observed in Q2CY09 only which can be RiskWeightedCAR* 12.3 13.5 14.0 13.9 attributed to the multipliereffect of credit Tier1CapitaltoRWA* 10.2 11.3 11.6 11.7 expansionforcommodityfinance,andbanks NPLstototalloans 10.5 11.5 12.6 12.9 effortstomobilizedepositstomeetendJune ProvisionstoNPLs 69.6 70.2 69.9 73.2 targets. Unlike deposits, total borrowings NetNPLstocapital 19.4 18.6 20.4 17.2 declined by 14.2 percent in H1CY10 (as ROAaftertax 0.8 1.0 0.9 1.1 against an increase of 11.1 percent in H1 ROEaftertax 7.8 9.5 8.9 10.8 CY09). Detailed data shows that secured Liquidassetstototal 28.2 31.2 32.7 34.2 borrowings,whichconstitute83.6percentof assets 75.2 69.6 67.7 63.0 total borrowings, decreased by 18.8 percent AdvancestoDeposits *FiguresforCY08&H1CY09arebasedonBaselII in H1CY10. On the whole, borrowings from framework. both SBP and from the interbank market Sources:BSD,SBP showedsubstantialdecline. Unlike the doubledigit growth in the equity base during H1CY09, equity of the banking systemincreasedonlymarginallyby1.0percentinH1CY10.Componentwisedetailshows thatwhencomparedtothe3.4percentincreaseinH1CY09,banksreservesdeclinedby8.3 percentinH1CY10.Anothercomponentthatdampenedequitygrowthwastherevaluation of assets, which registered a deficit of 17.1 percent in H1CY10, in contrast to the 62.2 percentsurplusinH1CY09. GrowthinNPLs,akeyindicatorofcreditriskinthebankingsystem,continuedtodecelerate inH1CY10andincreasedby6.4inH1CY10,overendCY09.Thisrelativelysmallincreasein banksNPLsanddeclineinadvancesportfoliotranslatedintoanNPLstoloansratioof12.9 percent, as against 12.6 percent at endCY09 CY09. Despite the slowdown in growth of incremental NPLs, yet the provisioning expense related to the outstanding stock of NPLs increased in H1CY10. The banking sector booked provisioning expense of Rs 30.4 billion duringH1CY10,whichislessthanRs41.8billionrecordedin thecorrespondingperiodof the previous year. In absolute terms, banks net NPLs (NPLs net of provisions) reached Rs 123.1billionbyendH1CY10. AnassessmentofNPLsbycategoryrevealsthattherehasbeenacontinuousincreaseinflow ofNPLsinthelosscategory,whichgrewby28.4percentinH1CY10.Thisexplainstheneed for additional provisioning to accommodate aging of NPLs from partially provided to the fully provided category. Consequently, the provisioning coverage ratio increased to 73.2 percentbyendH1CY10,asagainst69.9percentatendCY09.
Thisgrowthindepositsisdrivenby8.8percentgrowthingovernmentdepositsand8.1percentgrowthinprivatesector deposits.
53
82
The shift in banks assets composition from advances to investment has had a beneficial impactontheliquidityprofileofthebankingsystemandpushedtheshareofliquidassetsin total assets to 34.2 percent by end H1CY10, as against 32.7 percent at endCY09. Improvementinliquidityoutlookisalsoevidentfromthedeclineintheadvancestodeposits ratio,anotherkeyindicatorofliquidityrisk,to63.0percentbyendH1CY10asagainst67.7 percent at end the of CY09. This development in H1CY10 emanates from the 7.1 percent increaseindepositsandamarginalcontractionof0.5percentinadvances. Asaresultofthesevariousdevelopments,banksriskbearingcapacityimprovedduringH1 CY10. The profitability position at endCY09 was sustained in H1CY10, and the banking sectorearnedaftertaxprofitofRs35.9billion,ascomparedtoprofitofRs28.6billioninH1 CY09.Otherconventionalindicatorsofprofitabilityalsoindicatesignsofimprovements:the aftertaxROAandROEofthebankingsectorforH1CY10was1.1percentand10.9percent, asagainst0.9percentand8.9percentforCY09,respectively. Solvency of the banking system is judged by the amount of capital available to withstand risks to banks risk profile, as well as by the capital adequacy ratio (CAR). In H1CY10, regulatory capital increased by Rs. 4.4 billion, to reach Rs. 602.9 billion. In view of the enhanced minimum capital requirements (MCR), banks are required 54 to increase their minimumcapitaltoRs7.0billionbyendCY10.Bankwiseanalysisshowsthat21outof40 banks are already compliant, and it is expected that the remaining 19 banks will enhance theircapitalbaseduringtheyeartomeetthecriteriasetforthbySBP. Onanoverallbasis,riskweightedassets(RWA)grewby1.8percentinH1CY10,asagainst theincreaseof1.3percentinH1CY09.Althoughtheshareof publicsectorinnetadvances has increased slightly, from 17.4 percent to 18.4 percent, yet the credit to Public Sector Enterprises (PSEs) increased by 59.4 percent,55 which partially explains the increase in creditRWAevenwhentherewasnetretirementinadvancesduringH1CY10.MarketRWA, on the other hand, constitute 5.6 percent of total RWA and decreased by 1.7 percent on account of expansion in banks investment portfolio in favor of zeroriskweighted government securities. Given these development, the CAR of the banking sector remained comfortable at 13.9 percent compared to 14.0 percent for CY09 and 13.5 percent for H1 CY09.AsimilardevelopmentisalsovisibleinthecorecapitaltoRWAsratio,whichreached 11.7 percent from 11.6 percent for CY09. As of endJune CY10, bankwise information indicates that 6 out of 40 banks, constituting 6.6 percent share in total assets, are not compliantwiththeminimumrequirementof10.0percentCAR.Toensuresystemicstability of the banking sector, SBP is encouraging merger/restructuring 56 of these noncompliant banks.Furthermore,netNPLstocapitalratio,whichfocusesonthreattocapitalbasefrom creditrisk,declinedfrom20.4percentatendCY09to17.2byendJuneCY10. Tosummarize,thereviewofthefirsthalfofCY10showsthatbankscontinuetoconsolidate their risk profile, a trend which started in CY09. Presently, the major risks facing banks include:(1)repricingoftheinvestmentportfoliowhichislargelyconcentratedinriskfree government securities in a rising interest rate environment; (b) credit concentration in commodity financing and in other government owned and controlled enterprises; and (c) lagged impact of the havoc caused by the nationwide flood, as potential risk to the credit portfolio and operational efficiency of those banks which were operating in the worsthit geographicalareas.However,thecontinuityofreformswillenhancethesystemicstabilityof thebankingsystem.
BSDCircularNo7datedApril15,2009. BasedondatafromStatisticsDepartment. 56QuarterlyPerformanceReviewoftheBankingSystem,June2010,StateBankofPakistan.
54 55
83
References
BankofInternationalSettlements(2001),BaselCommitteeonBankingSupervision, ConsultativeDocument,OperationalRisk,BIS. IMF(2010),WorldEconomicOutlook,October2010. Jobst,A.A.(2007),ConstraintsofconsistentOperationalRiskManagementand Regulation:DataCollectionandLossReporting,IMFWorkingPaperNo.254. StateBankofPakistan(2009),FinancialStabilityReview200809. StateBankofPakistan(2009),IslamicBankingBulletinOctDec2009.May,2010. StateBankofPakistan(2010),TheStateofPakistansEconomy200910,Annual Report,Volume1.
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4STABILITYOFTHEBANKINGSYSTEM

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Figure4.13d Mar09 Sep09 15 14

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RetailBanking Commercial Banking Banking Paymentand Settlement Agency Services

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