AURORA: The State Bank of Pakistan’s (SBP) Vision 2020 puts a great deal of emphasis on branchless and digital banking. In your opinion, is this emphasis justified?
SALIM RAZA: Branchless banking and digitisation carry significant advantages in the acceleration of financial service penetration. In Pakistan there are an estimated 115 million mobile phone users. Mobile phones were first used for remittances, but now the telecom companies as well as banks, like Tameer, are bolting on other services such as savings, life insurance; some are even looking at mobile lending, although in small amounts. Only about 12% of Pakistan’s population is banked, so there is room for tremendous expansion as the process snowballs. Mobile and netbased, fitforpurpose technology creates the potential for a mass consumer offering at little marginal cost, while banks are lumbered with the costs of legacy technology supporting numerous products and branch networks. Abroad digitisation has made significant inroads into conventional bank revenue. Globally, between 20 and 25% of bank revenues come from payment services and this is being encroached into quite rapidly. However, these services are ultimately offerings for the consumer market. So while inclusion may proceed apace, the larger issue of developmental lending still remains substantially unaddressed. Credit for SME expansion and for greater agricultural productivity is moribund, and project finance for infrastructure (taking actual project risk) does not exist. Banks diverted to investing in government securities, where the spread had been exceptionally higher, until recent months. The bloom is coming off the rose and as government spreads tighten, banks will have to get back to looking at enterprise lending as a major mainstay of their earnings.
A: Why is the bloom coming off the rose?
SR: Inflation has fallen and with it, the SBP’s policy rate. All short term money market rates follow the policy rate down. In 2009 and 2010 short term treasury bills paid 12 to 13%; today they pay six or 6.5%. Long term rates tracked the policy rate down. PIBs issued for a three-year period in 2013 were at about 12.5%; the three year PIB has been reissued at just under eight percent. Government securities have accounted for more than 55% of the earning assets of banks in recent years, so the potential impact on bank revenue may be significant. On the other hand, operating costs constitute 60% of the banks revenue. The costs associated with investing in government securities is negligible in the larger scheme of things; falling spreads then hit the bottom line. Banks are going to have to find ways of replacing this revenue with other initiatives to improve what otherwise could be a noticeable rise in their costincome ratios.
A: Initiatives such as?
SR: Going back to the SME market and looking at ways of going into agriculture are other important avenues. However, if banks are going to do SME/agri on any scale, they will need institutionalised support. Many years ago the Government set up a SME bank, which is now inactive. They also set up a SME Development Authority (SMEDA) as well as the Zarai Taraqiati Bank, which carries out about 40% of all agricultural lending. Yet, in total, agricultural loans account for only seven percent of bank lending – and given that this sector accounts for 22% of GDP, this is very small. In 2007, bank exposure among SMEs in Pakistan was about 17% of total loans, today it is under six percent. For banks to really open up the lending spigots to SME, it will be important for them to see that the sector’s challenges are being addressed through various forms of official institutional support. There are various ways in which official intervention can help. One would be the revitalisation of the existing (but largely moribund) institutions mentioned earlier and which the Government had created to play this role. If they are to play a catalytic role in addressing current issues, these institutions will need transformation and revitalisation through much more capital, and through the deepening of their professional and managerial skills. For example, the Zarai Taraqiati Bank needs to be able to take on much more lending. However, simply building lending capacity is not enough. Capacity for a range of advisory services needs to be provided. Farmers need support through consultancy arrangements, for example for input management, for efficient water management, etc. Critical also would be to help the farmer gain closer access to market prices. At the moment, the farmer gets the residual after a chain of intermediaries have taken their cut and which the farmer is in no position to check or control. A useful way to link farmers closer to market prices would be the introduction of commercial warehouse financing, as it operates in much of the world. Professionally managed warehouses, run by accredited collateral managers, would test and grade the stock farmers lodged with them, and issue receipts. Warehouse inventories would be quoted, and be tradeable, at the national commodity exchange. Farmers will thus have knowledge of market prices and could either sell the receipt, or finance it, through collateralisation with a bank. However, if we are going to develop warehouse financing, the Government will have to invest in organising the infrastructure, regulations and operating systems. For SMEs, there is a pressing need to revive the activities of the dormant SME Bank, and perhaps integrate it with SMEDA, as its advisory arm. The active presence of a dedicated SME lender, with ability to provide professional and technical assistance to borrowers, is likely to serve as a powerful stimulus in regenerating commercial bank attention to the SME sector. Similarly, for housing finance, the HBFC (House Building Finance Corporation) needs more capital, and needs to be able to develop its own low cost housing projects, working in partnership with builders and developers. Pakistan’s mortgage lending ratios are among the lowest in the world – 0.5 percent of GDP. Compare this to the UK and the US where they are at 85% to 90%. In India, they are at 11% or 12%; in Malaysia 30% and in Thailand 20%.
A: Why is mortgage lending so low?
SR: For commercial banks, the problem is a common lack of clear title deeds in most urban residential centres. The national land registry’s records have to be cleaned up. This is something within the powers of the Provincial Government and municipalities to achieve and corresponding progress would, ipso facto, accelerate the amount of finance available from banks. There are other issues, such as sticky tenancy rights, and slow acting processes for foreclosing on a property where the borrower has defaulted. But the main blockage has to do with clean title deeds.
A: Are there signs that any of these measures will be taken up by the Government?SR: It has been talked about but I cannot say I see a clear strategy. The SBP has set up specialised committees, prepared reports in consultation with bankers, market practitioners and stakeholders on all three subjects mentioned above – agricultural lending, SME escalation, and increasing lending for housing. However, the subjects have to become a priority for the Government. Banks would be greatly encouraged to enter these sectors if they see official determination to improve the creditworthiness of the sectors. The provincial banks can play important catalytic role, if so directed, because all the subjects we are talking about here come under provincial authority.
A: In what way could the provincial banks help in this respect?
SR: A big part of their deposit base is made up of relatively low cost government deposits placed within the province, while they lend and operate Pakistanwide. Their priority, instead, should be for development initiatives within their respective provinces. The provincial banks could take up strategic responsibility for working on ideas for the reform of development institutions such as the SME Bank, SMEDA and Zarai Taraqiati Bank. The provincial banks have ready access to the provincial government authorities. This gives them the natural potential to become strong intermediaries and advocates on behalf of these development institutions whenever the Government can assist in removing impediments posed by outdated or irrelevant laws or regulations.
A: What about corporate enterprise?
SR: Regular use of public markets for raising debt, on the part of our corporate sector, is long overdue. Public capital markets for debt can provide lower cost, and more flexible debt structures for issuers, than conventional bank credit. It is possible that there are companies here that are better rated by the rating agencies than the banks they borrow from, as was often the case in the US, in the late 60s and early 70s. When I joined Citibank in 1970, most of the Fortune 500 companies were borrowing from banks; 10 years down the line they were dealing with the markets directly.
A: What triggered this shift?
SR: Ratings are absolute; be it a bank or a company a rating has a corresponding return and the lower the rating the higher the cost. So, if a double ‘A’ rated company borrows from a single ‘A’ bank, the company may have been able to raise funds cheaper, by virtue of its rating. But the bond market would be usually a lower cost option, even without the rating difference, which is why the investment banks and security houses in the West were able to persuade rated companies to go directly to the market. Over the course of a decade, top rated companies transferred to the public debt markets. Banks then moved heavily into developing the neglected consumer market to make up the loss of what had been a big piece of their revenue. In Pakistan, some large companies have floated bonds (TFCs) but the volumes are less than two percent of bank loans – whereas in some developed markets, the private bond market can be even larger than the volume of corresponding credit from banks. We have not developed the momentum yet, where a large company can routinely access public debt markets. Cost is not the only advantage the bond market has to offer. Bonds can be structured more flexibly (convertible, callable, etc.) than conventional termcredit from banks, and so better match the issuer’s cash flow outcomes. Bank credit covenants tie companies up into having to meet a variety of quite tight ratios and conditions, whereas the bond market is substantially less restrictive. Bonds are distributed across a wide range of institutional and individual investors, providing issuers a deep and ready alternative to the banking market; some issuer presence in the bond market is necessary, in any case, to retain investor familiarity with its name and performance, and so retain ready market ‘space’ for the future.
A: Why isn’t this happening?
SR: There are different factors at work. For one thing, our financial market structure is overwhelmingly dominated by banks, and institutional funds (i.e. pension funds, insurance companies, mutual funds) are collectively less than 20% of bank deposits (in comparison, nonbank financial assets are significantly larger than banks’ assets in the US and EU). So market ‘space’ for bond placements is limited, unless the banks themselves become investors – which rather defeats the purpose. Then, the bond market needs to be able to offer both fixed and floating interest rates. Fixed interest rates are an important requirement for long term investment, anchoring the financial cost. The absence of fixed interest rate options by itself reduces, somewhat, the attraction of using the bond market for raising debt directly from the public (investor) market. We do not have the mechanism necessary to fix long term interest rates, because we lack depth and liquidity in government long term security issues. Banks need a benchmark against which they can establish the ‘market’ rate, and in developed markets, this benchmark, for respective long term maturities, is provided by the price of the respective tenor of government securities. Further, commercial banks would prefer to keep high rated corporate loans on their books, and not lose them to the bond market. So, although the commercial banks do have investment banking powers to underwrite corporate issues, they do not see any great incentive to do this. As for the corporate sector, because banks provide very competitive pricing, there is no great hunger on their part either to access public markets. It is the investment banks that should be marketing to the top corporates the advantages and attractions of using public debt markets. But the investment banks are too small, they do not have the balance sheet strength to undertake significant underwriting volumes; besides, they are dependent on borrowing from banks. All this can change – but that is another discussion.
A: What about the Islamic banks? What is their contribution to the overall banking sector?
SR: Islamic banks have been growing fast and successfully. They now account for some 12% of the total banking market. Some of them are setting the pace for this rapid growth; for example Meezan Bank has become the eight largest bank in Pakistan. Their expansion demonstrates that they also contribute significantly to stretching the frontiers of financial inclusion in Pakistan by drawing in people who would not have used the (conventional) banking system. With respect to new directions for our Islamic banks: a fundamental need for our businesses, SME and some of the smaller corporates, is access to different forms of investor equity to supplement their own capital (most would not qualify for public listing, being too small, or too early in their business model). Globally, this type of equity is provided by different types of venture capital investors, and by specialist funds. This is a natural area for our Islamic banks to enter, as the heart of Islamic banking focuses on equity partnership.
A: Could you explain this further?
SR: Islamic banking is ultimately about risk sharing partnership. Selectively, Islamic banks should consider equity partnership and advisory services for target companies, where they recognise entrepreneurial talent and potential for growth. This is an area where Islamic banking can play a pioneering role. They have a large array of flexible products and this would be one extra step that would fit the essence of the Islamic banking model. If they took the initiative, they could open the path to growth of conventional venture capital investment, on a much broader scale. Of course, there will be regulatory aspects here that will need to be addressed – but let’s start the discussion..