Life of small and medium size banks in Pakistan is getting tougher, under the rules of minimum rates on interest bearing deposits in days of thinning spreads. The world is moving in a direction, where the mantra of ‘too big to fail’ is losing steam as big banks create systematic risk to economies and can potentially become white elephants.

During 2004-07, banks in Pakistan exploited rising interest rates by not passing the benefit to depositors and their spreads were rosier before the then SBP governor Shamshad Akthar intervened in May 2008 to introduce minimum deposits rates of 5 percent. The 3-month Treasury bill rate was hovering around 12-13 percent in 2008-09, and it was the right move by the SBP to safeguard the interest of depositors.

The minimum 5 percent rates on saving deposits continued till April 2012; and it was increased to 6 percent in May 2012. Ironically, Treasury bill yields were moving in lower range of 9-10 percent during that time. The pressure was already on the small banks to compete. In October 2013, after the SBP introduced interest rate corridor, the minimum return of deposits was fixed at 50 bps below the floor of the corridor while the interest rates corridor was of 300 bps.

The actual minimum deposit rate was 6.5 percent in October 2013 and it was at 7 percent during Dec13-Nov 14, while 3M T-Bills remained below 10 percent. Thus spreads between 3M paper to minimum deposits rate reduced from an average of 7.5 percent in 2008-100 to 2.9 percent in 2014. The administration cost of small banks is no comparison to that of the big five, and there is no way small banks can make profits on such thin spreads. In pre-2008 crisis days banks used to lend to risky ventures in private sector; but that came with a cost. The loan recovery is too hard given, poor enforcement laws as there is virtually no way to recover from defaulters – Dewan and Gulistan are living examples. And that explains Rs619 billion gross non performing loans against the advances of Rs5.3 trillion (infection ratio:11.7%).

Post-2008, banks refrained from aggressive lending to private sector and built the asset base on government papers while the attempt was to lower the cost of funds through higher CASA. And within CASA, the real juice is in CA as the spreads on SA are too low today. Today, around one third bank deposits are current accounts, while the rest are interest bearing.

Since May 2015, the interest rates corridor is thinned to 200 bps from initial 300 bps with t-bills rates pegged to the ceiling and minimum deposits to the floor. Hence, overall spreads are squeezing. Since May 2015, the spreads are at 2 percent, the question is how the small and medium size banks have survived in such times.

Recall that the government has been re-profiling the maturity of its domestic debt through PIBs and banks gladly took positions in long term papers during 2014 to book gains in anticipation of falling interest rates. During 2014 alone, fresh issuance of PIBs was Rs2.3 trillion against the target Rs0.9 trillion. A good chunk of these PIBs matured in July 2016; and banks may not be interested in taking fresh positions to the same tune as interest rates are expected to move up in next two years.

This is a pressure cooker situation for small and medium banks to sustain. Big banks have inherently low cost of funds due to sticky current accounts and low administration cost owing to extended outreach. But other banks will find it difficult to breathe in this suffocating environment.

This is essentially creating a monopolistic structure for big banks as, if the issue of spreads for small banks is not addressed, there will be more consolidation in banking industry. After MCB-NIB merger, there might be more in the offing. Return on investment ought to fall for small banks and with minimum capital requirement of Rs10 billion, sponsors may soon start thinking to exit. Central bank has to counter the trend and should come up with a policy framework to not let small and medium sized banks fail.