Banks profits vulnerable to sharp policy rate cut

KARACHI: The State Bank of Pakistan (SBP) has warned that any sharp cut in the discount rate can affect banks earnings as source of profits is shifting away from interest income to investment in the government securities.

“Growth in government borrowings has shored up banks’ earnings,” said the Financial Stability Review for the first half of 2011 released by SBP on Friday. “This trend is neither desirable nor sustainable, first because it compromises intermediation function and second as any sharp cut in discount rate can discernibly affect banks’ profits,” it added.

The report said that the returns from investments in government papers now accounts for almost 30 percent of banks’ interest income, up from 24 percent in June 2010.

The SBP said that the current monetary policy stance would make banks’ asset selection challenging in the months ahead. “Banks will either have to live with lower returns on their investments (a key contribution to profits in recent times) or to aim for greater private sector credit, which in a difficult economic environment, would truly test their ability to adroitly manage an already high credit risk,” it added.

The central bank in July and October cut discount rate by 200 basis points. It, however, kept the policy rate unchanged at 12 percent in November review.

Referring to the future outlook, the SBP report said that a mild pick-up in the private sector credit is likely as borrowing cycle of some key industries resumes, though receding commodity prices would keep the growth in check. “Further, the challenging business environment in general and banks’ risk aversion amid high credit risk would limit the possibility of a perceptible reversal in asset mix away from the government papers,” it added.

The report also warned that shift of borrowing pattern from SBP to commercial banks will worsen budget deficit. “It is likely to aggravate the budget deficit as return on government securities is now being earned by commercial banks instead of SBP,” it added.

The commercial banks are major source of budget financing since November, 2010 as government shifted its borrowing away from the central bank.

The report said that credit risk remained a major challenge as banks accumulated Rs31 billion of fresh non-performing loans, pushing infection ratio from 14.7 percent to 15.3 percent. Public sector commercial banks and mid-sized local private banks appear more vulnerable to higher credit risk, it added.

“However, going forward, the results of the stress tests showed that the banking system is resilient to shocks emanating from a challenging macroeconomic and business environment,” it observed.

Banks appetite for investment in government papers continues unabated, pushing the share of net investment in banks’ total assets to 34 percent, highest in a decade, it added.

According to the report, overall the assets of the banking system rose eight percent or Rs577 billion to Rs7.7 trillion during the first half of calendar year 2011. Deposits increased by 9.4 percent, registering the highest half yearly growth during the last four years, it said, adding that net investments, with an increase of 22.4 percent during the first half of 2011, markedly outpaced the anemic growth of 1.04 percent in net advances.

Profits before tax of banks were up by 31 percent during the first half of 2011 to reach Rs77 billion, with return on assets (ROA) of 2.1 percent (1.8 percent in June-10) and return on equity (ROE) of 21.9 percent (17.7 percent in June-10).

The review said that concentration in profits have dropped as share of top five banks down from 95 percent in Dec., 2010 to 78 percent in June 2011, ensuring that even smaller banks have a share, albeit marginal, in industry profits.

“Further, growing profits have also helped reduce the number of loss making banks, from 17 in June 2010 to 8 in June 2011,” it said.

The review said that Islamic banking institutions (IBIs) have registered 17.5 percent growth during the period under review, with bulk of incremental assets channeled into government securities.

Islamic banks appear more liquid, solvent and profitable when compared with rest of the banking sector but they face unique risks like reputational risk and displaced commercial risk.

The SBP said that domestic financial markets remained stable during the half year under review, despite some bouts of mild strain.

External inflows kept the value of domestic currency almost stable, as PKR depreciated by a marginal (0.35 percent) against the dollar.

The capital market managed to post a growth of 4 percent during the half year under review.

The central bank report said that during the period under review, the asset base of the development finance institutions (DFIs) managed to grow marginally by 4 percent, primarily on account of stronger growth in investments.

The trading volumes and activities in the corporate debt market largely remained low. The derivatives market shrank further as insipid credit to private sector coupled with stable exchange rate and interest rate environment dampened the demand for new derivative contracts, the SBP said.

The report said that in contrast, the mutual funds industry witnessed its revival as the money market investments improved the net assets of the industry by 24 percent. The insurance industry witnessed a growth of 16.6 percent in its asset base with the life business experienced a much strong growth of 24 percent, it added.