^[56] IH&SMEFD Circular Letter No. 02 of 2018

 

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2 Financial Markets Risk Analysis

Deteriorating economic conditions and uncertainty among market participants about future economic direction have kept the financial markets under stress. The forex and equity markets have witnessed higher volatility in CY18, while the money market has remained calm. The dearth of US dollar liquidity in the domestic economy has been an important aspect of markets behavior and the associated spillover effects. Going forward, the stability of the financial markets largely depends upon the intended outcome of the corrective policy measures taken to address the economic imbalances.

 

Vulnerabilities might be building up in the global financial markets…

In recent years, global valuations across a broad range of asset classes (equities and bonds)—driven by strong global growth, low inflation and largely accommodative monetary policies—have remained high. The rising asset prices along with lower volatility, growing leverage in non-financial sector and continued deterioration in under-writing standards represent build-up of significant financial vulnerabilities. ^{[1] , [2]}

In 2018, escalating trade tensions, concerns about possible rise in inflation due to strong wage growth in the US and measured hike in federal funds rate resulted in bouts of volatility in the 1^st and 4^th quarter of the year. (See Chapter 1.) However, the financial conditions have remained relatively easy in Advanced Economies (AEs), mainly US and EU, which have contributed to further buildup of financial vulnerabilities.

As far as the vulnerabilities in the Emerging Markets and Developing Economies (EMDEs) are concerned, they remain moderate at large. For some EMDEs (e.g. Turkey and Argentina), however, the stress ^[3] has risen due to higher external leverage, weak policy buffers, geopolitical tensions, and escalated trade tensions. The jittery sentiments in such markets have not spread to other EMDEs because the country-specific factors seem to be instrumental in investors’ decisions^{. [4]}

Going forward, further escalation of trade dispute between the USA and China, geopolitical risks, and any negative growth shock could lead to widespread volatility, higher risk premia, re-pricing in financial assets and increased financial system stress at the global level. The monetary policy direction in AEs, especially in the US, also remains a key risk factor in this regard.

Volatility in domestic financial markets–driven by idiosyncratic conditions—has risen in CY18…

In CY18, rising twin deficits, inflationary pressures and uncertainty among market participants about economic outlook has translated into higher volatility in the forex and equity markets (Chart 2.1). The exchange rate has cumulatively depreciated by 23.61 percent against the US dollar in CY18. In similar vein, domestic equity market was down by 7.58 percent (on average). Accordingly, stress in financial markets ^[5] has risen to higher level (Chart 2.2). However, volatility in money market, on average, has remained contained due to interest rate corridor mechanism in place, prudent management of market liquidity by SBP and better liquidity conditions prevailing in the last quarter of the year.

Rising current account deficit leading to depreciation of domestic currency

The continued surge in trade deficit ^[6] during CY18 has resulted in surge in the current account deficit, which contracted the SBP foreign exchange reserves by USD 6.9 billion to reach USD 7.2 billion or equivalent to 1.5 months of imports. (Chart 2.3). Because of weakening in capacity to finance imports, PKR has cumulatively depreciated by 23.61 percent ^[7] during CY18. Resultantly, volatility in the inter-bank forex and open markets has risen to a notable scale (Chart 2.4a & b). In addition, the average spread (between open market and the inter-bank exchange rates) during CY18 has remained at PKR 1—lower than PKR 2 in CY17, suggesting increased synchronization between interbank and open markets.

 

Changing exchange rate dynamics have influenced economic agents’ behavior…

The notable adjustment in exchange rate has affected price and volume of short-term and long-term financial instruments, respectively. Lower interest rates differential kept the forward premium/Swap points ^[8] —a short-term forex instrument— lower during H1CY18 as compared to the previous year (Chart 2.5a, 2.6a). ^[9] However, in H2CY18—despite notable interest rate spread between domestic and international interest rates—forward premium has remained compressed (Chart 2.5b). This indicates higher demand for US dollars in the domestic market due to increase in external sector vulnerabilities. ^[10] (Chart 2.6b)

Similarly, in case of longer-term financial instruments (such as the derivatives) a compositional change is quite apparent. While, in CY17, most of the derivative deals comprised of interest rates swaps (IRS), ^[11] the cross currency swaps (CCS) ^[12] have dominated the derivative market transactions in CY18. ^[13] This reflects the rising tendency of the market participants to hedge themselves against the growing exchange rate risk.

Besides influencing the price and volume of financial instruments, the changing exchange rate dynamics may alter the borrowing pattern of businesses as well. When a firm envisages expansion, it takes into account exchange rate dynamics to determine its cost of imports. In times of rising forex market volatility, the investors’ long-term financing appetite, generally, dwindles. This may be evident from the decelerating private sector fixed investment advances that expanded by 8.25 percent in CY18—down from 14.97 percent growth in CY17 (Chart 2.7a). Moreover, in volatile times, pricing of foreign currency loans becomes expensive and demand recedes. The abating level of foreign currency loans confirms this assertion. (Chart 2.7b). Therefore, the stability in the FX market is important for increased business confidence.

Interest rates at the short-end of the yield curve have moved up in tandem with monetary policy tightening….

The policy rate—after remaining unchanged since Jun-16—began to move up in Jan-18. Rising inflationary pressures and higher fiscal and current account deficits explain the successive increases in policy rate during CY18 (Chart 2.8). Cumulatively, policy rate has risen by 425 basis points to reach at 10.0 percent in Dec-18. Accordingly, the short-term interest rates on government securities have inched up in the secondary market (Chart 2.9a).

…and the interest rates at the long-end of the yield curve have inched up…

In CY17, yield on long-term government securities averaged at 7.38 percent. With rise in policy rate in CY18, average yield has increased by 200 basis points to 9.35 percent (Chart 2.9b). However, in perspective of term premium ^[14] , the yield on long-term securities has risen to a lesser extent as compared to the short-term securities. As a result, the term-premium is trending downwards. This may suggest less than optimistic expectations of market participants about the future economic prospects.

In the secondary market, most of the trading activity of government securities during CY18 has taken place in maturities of up to 3 months, mirroring the primary market developments (increasing interest in short-term securities by market participants) (Chart 2.10). Thin trading in longer-term maturities may undermine their true price discovery, besides reflecting the risk averse behavior of market participants.

Government’s borrowing pattern as well as market’s bidding behavior have remained key drivers of money market volatility…

In CY18, overnight repo rate, on average, has been one basis point above the policy rate (versus 7 basis points higher in CY17). The average volatility has also remained at a lower level in CY18 compared to CY17. However, dynamics of the overnight repo rate during the year reveals that—from Apr-18 to Aug-18—volatility has remained high and it declined only towards the end of CY18 (Chart 2.11).

The liquidity conditions in the money market are strongly influenced by the government’s institutional choice for budgetary borrowings as well as market participant’s appetite for government bonds. Due to transition in government during the mid of the year, consistency in choice of government borrowing has been effected, which increased uncertainty and volatility in the market during Apr-Aug 18. Moreover, during the same period, banks have not been a willing lender to the government, which added to the volatility.

Moreover, SBP has had to calibrate its market interventions according to the liquidity conditions existing in the market (Chart 2.12 and 2.13). It has made injections until Aug 18 and thereafter mostly mop-ups. It is interesting to note that despite injections during Apr-Aug 18, the money market has remained volatile, due to government’s borrowing pattern.

Banks increasingly invested in short-term treasury bills…

The analysis of primary market reveals that the banks have been actively participating in 3 months treasury bills auctions since latter half of CY17, while their participation in 6 months and 12 months treasury bills auctions have remained negligible (Chart 2.14). ^{[15] , [16]} This is mainly due to higher interest rate expectations—a fact corroborated by decreasing interest of banks in long-term government securities (PIBs). The banks have not only demanded higher returns on PIBs during CY18 but have also offered lower amounts (Chart 2.15). ^[17] This also suggests that the formation of higher interest rate expectations by the market participants began a few months prior to the monetary policy tightening.

…leading to higher rollover risk for the Government

Banks interest in short-term government securities have led to further increase in rollover risk for the government ^[18] . The share of MTBs in total government debt from the banking sector has increased to 65.86 percent in Dec-18 from 57.06 percent a year ago, while that of PIBs has declined to 28.07 percent in Dec-18 from 37.17 percent in Dec-17 (Chart 2.16).

The equity market valuation is trending downwards…

In CY18, equity market—down by 7.58 percent on average—has remained bearish and range bound (Chart 2.17). Tightening macrofinancial conditions (rise in interest rates, exchange rate depreciation, inflationary pressures etc.), uncertainty (arising from political transition), and net-foreign outflows in response to persistent increase in the Federal funds rate have contributed to the equity market slowdown. As a result, the market capitalization has reduced by 10.25 percent during CY18 (versus 10.98 percent decline in CY17) (Table 2.1).

The corporate profitability has also come under pressure as their earnings ^[19] growth declined to 2.91 percent in CY18 from 18.77 percent a year earlier. ^[20] (See Chapter 5). This along with PKR depreciation has resulted in reduced dividends (USD 1.9 billion in CY18 versus USD 2.4 billion in CY17) on foreign portfolio (in dollar terms) and inflow of direct investments. With decline in market prices and the corporate earnings, the average Price-to-Earnings ratio (P/E) has also reduced to 9.24 in CY18 against 10.18 in CY17. (Chart 2.18).  Further, the investors became risk averse and refrained from taking aggressive positions, which has squeezed trading volume in equity to 194 million shares in CY18 against 249 million shares in CY17 (Chart 2.19). 

…leading to increase in risk aversion…

The narrowing gap between earnings yield ^[21] in equities and risk-free money market instruments in CY18 has compounded the risk averse behavior (Chart 2.20). This is evident from the changing composition of asset portfolio held by the mutual funds. The share of money market assets (in total assets) has increased to 27.67 percent (17.42 percent in Dec-17), while the exposure to equity market has declined to 37.43 percent (41.90 percent in Dec-17) (Chart 2.21).

Increased risk aversion is also reflected in the persistent net outflow of foreign portfolio investment (Chart 2.22). ^[22] Though the foreign investors has been net sellers in the previous year as well, the bearish sentiment has been re-enforced by the fading macroeconomic prospects. ^[23]  

…and rise in market volatility

The non-conducive market conditions have kept the volatility in the equity market at elevated level (Chart 2.17). Notably, the nervous withdrawal by the foreign investors from the market could have resulted in higher volatility, had it not been mitigated by active participation of domestic institutional investors such as Insurance (Chart 2.23).

Though, the downside risks to equity market returns remain muted…

Value at Risk ^[24] (VaR) analysis indicates that—despite the prevailing stress in the equity market—downside risks to the market returns have remained contained during CY18 (Chart 2.24). The actual returns of KSE-100 index have breached the VaR measure with lower frequency (17 times in CY18 vs. 20 times in CY17). Moreover, unlike CY17, the returns have not dipped below the stressed VaR ^[25] during CY18.

The equity market returns are in-sync with MSCI Emerging Market Index …

The synchronized behavior of KSE-100 index with MSCI EM index during CY18 suggests that the idiosyncratic vulnerabilities experienced by the EMDEs as a group have been aggravated by the external environment. ^[26]

Moreover, the correlation between domestic equity market and S&P 500 index has not only weakened over-time but it has also turned negative in H2CY18 (Chart 2.25). This recent decoupling suggests the growing chasm between the business cycles of the US and domestic economy, the “flight to safety” motive of global investors, and weakening of spillover effect through trade channel in view of the protectionist stance in the US.

Going forward, the stability in financial markets hinges on several factors…

Domestic financial markets—particularly forex and equity markets—in CY18 have remained volatile primarily due to external account pressures, higher fiscal deficit, rising inflationary pressures, and elevated uncertainty among market participants. In addition, the dearth of US dollar liquidity has been important aspect of financial markets behavior and connectivity during CY18 (see Box 3).

Going forward, improved stability in the financial markets—particularly forex and equity markets—largely depends on (i) how effectively the dearth of forex market liquidity is addressed; (ii) the realization of anticipated outcomes of corrective policy measures; (iii) the direction of investors’ sentiments; and (iv) the successful implementation of the IMF program.

 

Box 3: US Dollar Liquidity Remains an Important Aspect of Inter-Connectedness and Financial Markets Behavior during CY18

In CY18, US dollar liquidity has remained one of the important aspects of connectivity in domestic financial markets. Forex market developments have affected equity market through lower dollar adjusted returns ^[27]  on foreign investment and rising inflation (exchange rate pass-through impact). Lower dollar adjusted returns have resulted in net outflow of foreign portfolio investment exerting pressure on equity market and exchange rate (Chart A1). ^[28] With rising inflation, SBP increased its policy rate, which in turn translated into higher lending rates thereby increasing cost of borrowing for the corporate sector. Resultantly, increased financial expenses undermined corporate earnings and added to selling pressure in the equity market.

Also, rising yield in money market instruments (treasury bills) concomitant with falling stocks prices have triggered investment flows towards money market funds from the equity market.

The link between forex and money market is also reflected through forward premium. Rising interest rates in the domestic market –relative to the interest rates in foreign markets—should make up higher forward premium in forex swap transactions. However, despite notably higher interest rate spread, forward premium during H2CY18 has remained squeezed due to the dearth of dollar liquidity coupled with expectations of PKR depreciation in the domestic market.

To conclude, US dollar liquidity has played vital role in explaining the behavior and inter-connectedness of financial markets during CY18.

 

 

 

 

      

 

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^[1] (a)Reserve Bank of Australia (2018). Financial Stability Review. October.

(b) Low risk free rates—in the backdrop of accommodative monetary policy—are driving up asset prices, as these rates are central to many asset prices.

^[2] (a)Standard valuation metrics suggest that equity prices in the USA are hovering at levels significantly above its historical norm.

(b) According to IMF (Global Financial Stability Report-2018),total nonfinancial sector debt in jurisdictions with systemically important financial sectors has grown from $113 trillion (more than 200 percent of their combined GDP) in 2008 to $167 trillion (close to 250 percent of their combined GDP).

^[3] Stress represents rising bond spread, declining equity prices and notable currency depreciation.

^[4] IMF. (2018). Global Financial Stability Report. Washington, October.

^[5] Financial Market Stress Index is a composite indicator that measures the level of stress emerging from foreign exchange, money, and equity markets. For technical details see Appendix A.

^[6] In CY18, trade deficit stands at USD 33 billion against USD 31 billion in CY17.

^[7] On average, exchange rate has depreciated by 15.48 percent during CY18.

^[8] Forward premium on currency swap is based on interest rate differential prevailing between two currencies in a pair. Higher the differential implies higher forward premium. However, the settlement of interest rate spread at par requires easy liquidity conditions of both currencies involved. For instance, if US dollar liquidity is tight in the domestic market then in such conditions, the US dollar lender would pay less premium than what interest rate differential suggest against PKR borrowing.

^[9] Lower spread in H1CY18—compared to H1CY17—has been on account of consistent increase in LIBOR.

^[10] SBP net reserves, on average, stood at USD 8 billion in H2CY18 against USD at 14 billion in H2CY17.

^[11] In CY18, IRS deals amount to PKR 19 billion—down from PKR 23 billion in CY17.

^[12] In CSS deals, counterparties exchange two different currencies at spot rate at the inception of the contract. Both parties receive interest rates on lending currency and pay on borrowed currency. The currencies are exchanges at the end of the contract with pre-determined exchange rate.

^[13] In CY18, CSS deals amount to PKR 22 billion—up from 11 billion in CY17.

^[14] The term-premium has been proxied by the spread between long-term (3Y PIBs) and short-term (3M T-bills) yield.

^[15] CY17 statistics show that out of the total 26 auctions held for 6M treasury bills, banks—with one rejection—participated in 25 auctions. However, in CY18, participation is down to 13 auctions with 6 rejections due to higher bidding.

^[16] Banks participated in 20 auctions against 12M treasury bills during CY17 while 4 were rejected. In CY18, banks have participated just in one auction which has been rejected.

^[17] In CY18, most of the bids have been rejected in PIBs.

^[18] Re-pricing of the debt with higher frequency could lead to higher cost of debt servicing especially in rising interest rate scenario.

^[19] Earnings before interest and taxes (EBIT). It represents 303 firms listed on Pakistan Stock Exchange

^[20] Financial expenses of 303 listed firms are higher by 19.35 percent in CY18 as compared to CY17.

^[21] Earnings yield refer to the earnings per share for the most recent 12-month period divided by the current market price per share.

^[22] In CY18, cumulative net foreign investment outflow from equities stands at USD 647 million against USD 447 million in CY17.

^[23] Pakistan’s sovereign risk ratings by Fitch has been revised downward to B in Jan-18 and further to B Negative in Dec-18.

^[24] VaR represents the probable amount (or percentage) of downside risk of investment at any given point in time. Here, to assess the riskiness of KSE returns, 100 days rolling Historical and Normal VaR along with stressed VaR (SVaR), at 95 percent confidence level, have been computed.

^[25] Stressed VaR refers to minimum 100-days rolling value during the entire sample period (January 2001-December 2018).

^[26] The correlation coefficient turns out 0.78 between MSCI EM and KSE-100 index during CY18. Moreover, the returns (on average) of MSCI EM (-.06 percent) and KSE-100 index (-.05 percent) have been almost the same.

^[27] Exchange rate depreciation results into lower dollar adjusted returns as foreign investment return on equity is measured in PKR. Therefore, returns deliver back less dollars in case of domestic currency depreciation.

^[28] During CY18, except the month of January, equity market has observed consistent net foreign investment outflow.

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Top

Section A: Banking Sector

3.1    Performance and Risk Analysis of the Banking Sector

The banking sector has remained resilient during 2018 despite challenging macrofinancial conditions. The solvency has further improved, the fund-based liquidity has remained at a comfortable level and the interconnectedness within the banking sector has stayed unchanged. The financing growth has surged and the Non-Performing Loan ratios has touched its lowest level since CY08, though quantum of Non-Performing Loans has increased. Deposits, despite some deceleration, have remained the mainstay on the funding side. The pace of decline in profitability has receded and the reliance on interest income has increased. Going forward, credit, market and other emerging risks (such as AML/CFT and Cybersecurity) may pose significant challenges for the banking sector, though. The banks may also encounter funding constraints if the deceleration in deposit growth prolongs.

 

Banking sector responds well to the tighter macrofinancial conditions…

During CY18, the banking sector has weathered the macrofinancial headwinds with limited impact on performance and soundness.

The asset growth of the banking sector has decelerated mainly due to net-maturity of long-term government bonds. The liquidity thus generated, in addition to support from growth in deposits, has not only enabled banks to meet higher cost-push financing demand but also lowered their borrowings (Chart 3.1.1). Encouragingly, advances disbursements have been broad-based to multiple economic sectors leading to uptick in “advances to deposit” ratio. The asset quality has observed a mixed trend with Non-Performing Loans (NPLs) ratio continuing to decline, albeit, with increase in quantum of NPLs.

The profitability of the banking sector has continued to moderate during the year. However, the pace of decline has receded due to rising volume of interest income coming from healthy growth in advances and increase in interest rates.

The level of interconnectedness remains similar to last year with decline in volume of unsecured borrowing and lending. The solvency has further strengthened with CAR inching up to 16.2 percent, which is well above both the global and local minimum benchmarks. However, few small banks are facing challenges on liquidity and solvency fronts.

The consolidated picture of key risk dimensions of the banking sector has improved which is evident from the Banking Sector Stability Map (BSSM) and Banking Sector Vulnerability Index (BSVI) (Chart 3.1.2 and 3.1.3).

1. Asset Quality

Credit risk of the banking sector in Pakistan mostly emerges from loans, as the banks have limited exposure in private sector debt instruments (e.g. Term Finance Certificates, Sukuk, debentures etc.). In addition, the significant holding of domestic government securities carries only market risk, as it attracts zero credit risk weight under Basel III capital adequacy rules.

The NPLs of banking sector advances rises…

NPLs, which had been hovering around PKR 600 billion during CY11-17, have escalated by 14.7 percent to reach PKR 680 billion by end of CY18, both, due to addition of fresh NPLs and lower cash recoveries.

Most of the fresh domestic NPLs have emerged in sugar, agriculture, and production and transmission of energy sectors along with individuals. The low market price of sugar and ongoing legal proceedings against one of the corporate groups, with large exposure in sugar, has resulted in classification of loans in this sector. Also, the delayed purchase and crushing of sugarcane by the sugar mills restrained farmers from fulfilling their financing obligations to banks on time. The rise in agriculture sector NPLs results from low yields owing to water shortage and drought conditions, late procurement of wheat by public procurement agencies, default in government declared “calamity affected area”, and rise in input prices (such as seed, fertilizers, pesticides, electricity and POL) due to PKR depreciation.

Besides domestic defaults, foreign operations of banking sector have contributed 39.02 percent in the flow of NPLs during CY18. This mostly relates to few banks’ exposure in GCC countries. These bad loans, mostly, pertain to electronics appliances and automobiles sectors as well as individuals. In addition, PKR amount of foreign operations’ NPLs has, partially, escalated due to depreciation of domestic currency. 

…but, the advances growth accelerates…

The growth momentum in advances has accelerated in CY18. The gross advances have risen by 21.27 percent in CY18 compared to 16.90 percent in CY17. The key thrust has come from domestic advances (both private and public). Resultantly, advances to deposit ratio has inched up to 55.81 percent; the highest level since Q4CY11.

The domestic private sector has observed an active buildup of financing flows of 20.0 percent across the corporates, SMEs, consumers and commodity operations. There has been strong growth in working capital financing followed by trade finance (Chart 3.1.4). Sector-wise, the major private borrowing pertains to textile, food and beverages, cement, production and transmission of energy, chemicals, real estate sectors etc.

The public sector advances, up by 28.47 percent, has major contribution from fixed investment loans due to settlement of circular debt through state owned Power Holding Private Limited (PHPL), project expansion and Balancing, Modernization, and Replacement (BMR)  (Chart 3.1.4).

However, rise in financing urges caution…

The following factors suggest that advances growth may be viewed with caution:

(a) The rise in working capital flows is mainly due to higher input/raw material prices owing to PKR depreciation (Chart 3.1.5). This is evident from the slow real economic activity in the manufacturing sector. The large-scale manufacturing (LSM) index has observed a growth of only 1.40 percent in CY18.

(b) After growing persistently during the last few years, the private sector fixed investment financing growth has decelerated to 8.25 percent, in CY18 compareto 14.97 percent in CY17. A broad based deceleration has occurred in various sectors including textile, construction, transport, storage and communication, chemicals and chemical products. This contraction in demand is likely due to (i) tightening of macro-financial conditions (ii) completion of ancillary projects (mostly infrastructure and power) related to CPEC and (iii) downbeat investor sentiments. ^[1]

(c) The liquidity glut has induced banks to not only offer loans at lower margins but increase the average loan size also. ^{[2] , [3]} Due to high competition in extending loans, banks have offered financing even at KIBOR, which means that banks have assumed credit risk on their corporate clients at par with their interbank exposures (underpricing of risk). ^[4] Moreover, though the number of private business loan applications have reduced from 1.33 million in CY17 to 0.76 million in CY18, the average loan size has more than doubled (from PKR 3,389 in CY17 to PKR 6,887 in CY18).  

(d) The reviewed year has witnessed higher financing demand in production and transmission of energy sector. However, a significant portion of public sector financing has been utilized for the settlement of circular debt and hydel payments by federal government to the provincial government using one of the PSEs as a vehicle for routing funds.

(e)  Consumer financing has increased by 19.74 percent, primarily, due to pick-up in personal loans category. The growth in auto loan, a key contributor in consumer financing since the last few years, has decelerated due to bar placed on non-filers from purchasing/ registering vehicles.

As the financing growth outpaces NPLs buildup, the infection ratio slides…

Due to higher proportionate growth in advances than NPLs, the overall NPLs ratio has reduced to 7.97 percent by end CY18 compared to 8.43 percent in CY17. The fall is obvious in most of the key sectors, except sugar (Figure 3.1.6).  Textile sector, which is the largest borrower of the banking sector, has witnessed a dip in the infection ratio as well as in absolute value of NPLs.

…though net credit risk rises for specialized and local private banks…

The provision coverage ratio has come down from 87.24 percent in CY17 to 83.80 percent in CY18. This decline has largely resulted from increase in NPLs in Agriculture and sugar sector especially in case of Specialized and local private banks (Table 3.1.1). Consequently, the net-NPLs to net-loans ratio has risen to 1.38 percent as of end CY18 compared to 1.16 percent as of end CY17. Though the coverage still seems adequate, 20.40 percent of outstanding NPLs are still held in Other Asset Especially Mentioned (OAEM), subordinate and doubtful categories. Any further downgrading, going forward, may lead banks to bear additional provisioning expense (Figure 3.1.7).

While some small sized banks have become more vulnerable to credit risk…

During CY18, small sized banks (asset share: 8.04 percent) and very small size banks (asset share: 1.68 percent) have become more prone to credit risk with the rise in infection ratio as well as decline in the provisioning coverage ratio (Table 3.1.2). These are the banks, which contain major share in the flows of NPLs during the reviewed year. On the other hand, large and medium size banks have improved both in terms of infection ratio as well as provisioning coverage.

 

…and the lag impact of monetary tightening may impact asset quality…

Though banks’ fresh loans are disbursed at a higher rate in response to monetary tightening, there still exists a significant portion of outstanding loans, which may be repriced with some lag due to contractual bindings. The fact that major rise in policy rate has occurred towards the end of CY18 and beyond, the borrowers may face further hike in interest expense later on. This coupled with the lower corporate profitability may deteriorate the repayment capacity of borrowers and increase NPLs. Generally, a lag of four to six quarters exists between the rise in interest rates and the subsequent buildup of NPLs. ^[5]

Pro-cyclical systemic risk remains subdued, despite continuous growth in advances…

The growth momentum in advances since last few years and recent economic slowdown warrants an assessment of pro-cyclical systemic risk in the banking sector of Pakistan. ^{[6] , [7]}  The Advances to GDP ratio against its long-term trend, one of the commonly used indicators to assess pro-cyclical systemic risk, reveals that the gap has turned positive and is on the rise (Chart 3.1.8).

However, credit-overheating possibilities are remote because:

(a) The magnitude of advances to GDP ratio in Pakistan is, in itself, not that high compared to even the peer counterparts (Chart 3.1.9). The ratio in Pakistan has been hovering around 15-20 percent historically and peaked at 29.66 percent in 2007. It currently stands at 17.24 percent only. 

(b) The dominant channel of systemic risk where real estate collateral prices and credit expansion reinforces each other (e.g. Global Financial Crisis 2006-7) is weaker in Pakistan. The mortgage financing stands only at 0.25 percent of GDP and has a meager share of 1.07 percent in domestic lending portfolio. Further, residential real estate collateral secures only 11.35 percent of the banking exposure (Chart 3.1.10). ^[8]

(c) The limited cross-border exposure (both lending and borrowing) prevent the domestic financial system from external spillover effects of abrupt capital flows. .

(d) The regulatory structure is quite extensive. SBP, in its regulatory domain, has implemented the international best practices for enhancing the soundness of the banking sector, in particular, and financial system, in general ^[9] . Moreover, SBP as part of its strategic goal “Strengthening of the Financial Stability Regime” is working on putting in place an effective Macro Prudential Policy Framework. (See Box 1.1 on “SBP initiatives to strengthen financial stability”).

2. Deposits

The structural risk also remains muted as deposits continue to be the mainstay of funds leading …

The steady growth in deposits is pivotal for the banks as it is the major source of funding. Deposits constitute 77.99 percent of total liabilities and 72.42 percent of total assets, as of end CY18. The deposits have contributed 92.68 percent in the asset expansion during CY18.

During CY18, deposits have risen by 9.55 percent (Y-o-Y) versus 10.29 percent in CY17; the lowest since CY08 (Chart 3.1.11). This slowdown may be attributed to a mix of factors including (a) cost cutting strategy of some banks to limit the growth of domestic remunerative deposits, (b) scaling back of operations by few banks in overseas market, (c) probable dampening effect of withholding tax on banking transactions, (d) depositors concern regarding enhanced KYC requirements to contain AML/CFT risks, and (e) additional liquidity available as a result of net-maturity of investment.

In terms of category, deceleration in saving and fixed deposits have overshadowed the rise in current deposits (Chart 3.1.11). The saving deposits have become costly due to Minimum Saving Rate (MSR) policy in vogue. ^[10] Moreover, the fixed deposits could not attract the attention of banks due to maturity re-profiling of their assets, both, in investments (from PIBs to MTBs) and advances (from fixed term loans to short-term working capital financing).

The size-wise distribution of deposits is also important from the stability perspective. Generally, retail (small) deposits are more stable and have longer retention periods than the large size institutional deposits. Encouragingly, the reviewed year has witnessed growth in small sized retail deposits up to PKR 1.0 million. On the other hand, growth in deposits over PKR 10.0 million have been trending downwards (Chart 3.1.12). ^[11] This is due to declining flows of institutional deposits (NBFIs, PSEs etc.) as well as private business deposits, particularly, the manufacturing sector.

3. Interconnectedness ^[12]

The level of overall integration in the banking sector has almost stayed at the level as seen a year earlier. However, there is a compositional shift. While volume of call (unsecured) lending and borrowings during CY18 has reduced, the other interbank liability and assets have increased.

The lack of complexity in the financial sector, within itself, provides an inbuilt stabilizer against the cross-sectional systemic risk. The interbank exposure has low share in assets of the banking sector, as deposits are the key source of funding. Further, the interbank repo borrowings are, mostly, collateralized against highly liquid and credit risk free government securities. In addition, absence of exotic instruments and shallow capital market with limited debt instruments, keep the cross institutional exposure and, resultantly, the likelihood of cross-sectional systemic risk low.     

The presence of large sized institutions may enhance the likelihood and impact of systemic risk, though. Within the context of cross-institutional exposure, the weighted average probability of defaults (based on Merton model) of 5 largest banks has increased recently from 0.129 percent by end of CY17 to 0.188 percent by end of CY18 (Chart 3.1.13). ^[13] However, this narrowing distance to default seems to have emerged due to higher volatility in the equity market during CY18, instead of weakness in the fundamentals of these financial institutions as suggested by the BSSM (see Chapter 2).

4. Liquidity 

The fund-based liquidity of the banking sector is mostly contributed by holding of government papers. During CY18, the liquidity has slid down slightly due to net-maturity in banks’ holding of long-term PIBs. However, the overall liquidity, with liquid assets maintained at 48.69 percent of total assets and 94.85 percent of short-term liabilities, is still adequate to meet any contingent need of banks. ^[14] Similarly, eligible liquid assets against demand and time liabilities stand at 51.82 percent; well above the required level of 24 percent for CRR and SLR purpose (Chart 3.1.14). In terms of Basel III liquidity standards, banks have maintained liquidity coverage ratio (LCR) at 182.72 percent and net stable funding ratio (NSFR) at 156.13 percent (both, well above the minimum required ratios of 100 percent).

 …as the banks’ ability, to meet short-term obligations improve…

The banks renewed interest in MTBs has reshaped the asset-liability maturity profile of the banking sector in CY18 (Chart 3.1.15). The asset-liability gaps reveal that banks’ ability to meet short-term commitments has improved. On the other hand, the negative gap for maturity over one year has further widened in CY18 due to net-maturity of PIBs. However, once the interest rates stabilize, banks’ interest in PIBs may restore leading to a reduction in this gap.

 

However, smaller banks ability to meet obligations has receded…

The liquidity profile of the bottom two quartiles of banks (smaller banks) has been weakening during the last few years (Table 3.1.3). There has been quite a steep fall in liquidity ratio of both small and very-small banks in CY18. This is because some of these banks have utilized their liquid assets to fund their operations.

5. Profitability

The profitability of the banking sector has moderated for yet another year. Profit (after tax) at PKR 149 billion is down by 5.36 percent in CY18. This decline has resulted from (a) higher provisioning expense on bad debts and diminution in the value of investments; (b) decline in net gain on sale of securities; (c) reduced dividend income; and (d) rise in administrative cost including some extra ordinary expense borne by a couple of large banks (e.g. higher legal and professional charges and expense on defined benefit pension plan etc.). ^[15]  

Accordingly, all profitability indicators have shown slight deterioration. The after-tax ROA and ROE have dropped to 0.81 percent and 10.71 percent in CY18, respectively, from 0.92 percent and 11.53 percent, respectively, in CY17 (Chart 3.1.16). The cost to income ratio has slightly inched up to 60.21 percent in CY18 compared to 57.14 percent in CY17. In addition, the bank-wise distribution of after tax profit shows that the number of loss making banks has increased to 7 in CY18 from 5 in CY17. However, on aggregate, these banks have 3.70 percent share in the asset base of the banking sector and most of these are under the restructuring process.

…but earnings flow seems to have stabilized…

Despite moderation in profitability the Net Interest Margin (NIM), has improved from 3.34 percent in CY17 to 3.40 percent in CY18. In addition to healthy growth in advances, the policy rate hikes from second quarter of CY18 onwards, has increased the lending rates. This has bolstered the interest earnings of the banks as Net Interest Income (NII) has increased by 9.27 percent during CY18 from 2.90 percent in CY17. Moreover, lagged impact of increase in rates on repricing of existing outstanding loans is expected to further push the NIM upwards.

Further, with the sizeable maturity of long-term government bonds, the expected volume of losses on the sale of lower valued remaining securities, in the current rising interest rate scenario, may be limited. (Chart 3.1.17).

With the monetary tightening, banks adopted profit optimization strategies…

The mark-to-market yields on government papers rose significantly before five out of six SBP monetary policy announcements during CY18 (Chart 3.1.18). This advocates that banks had a strong rate rise expectation before the announcement of each monetary policy. 

In this scenario, banks have mostly preferred to invest in short-term instruments (3 month MTBs) and divest long-term instruments (PIBs) to limit deficit on revaluations (Chart 3.1.19). This behavior has also exhibited in primary auctions, where banks demanded higher average yields on PIBs (than offered coupon rates) to compensate for the expected revaluation of PIBs.

However, the realization of credit risk remains a key concern for profitability…

A sizable amount of provisioning charges has squeezed the bottom line of the banks. After accounting for the provisioning charges against NPLs and diminution in the value of investments, the growth in NII slides to 2.8 percent, which is lower than 3.3 percent in CY17.

…along with rising operational cost…

In addition to provisions charge, surge in administrative expenses has also affected the overall profitability. The administrative expense of the banking sector has exhibited a growth of 10.96 percent against 3-years (CY15-17) average of 8.40 percent (Table 3.1.4). Besides costs associated with normal operations such as branch expansion costs, the one-off costs (e.g. legal charges, postretirement benefit expenses) have also increased. As a result, both the fixed and variable components of administrative expenses have witnessed a surge.

6. Solvency

Despite emerging risks during CY18, the banking sector has remained resilient. The Capital Adequacy Ratio (CAR) of the banks has inched up to 16.19 percent as of end CY18 from 15.76 percent in CY17; well above the minimum local requirement of 11.9 percent and international benchmark of 10.50 percent. The tier 1 CAR has stood at 13.24 percent by end CY18 (Chart 3.1.20). The leverage ratio (LR) of the banking sector at 4.80 percent as of end CY18 is well above the minimum required level of 3.0 percent.

…as banks continue to take measures to enhance capital

As per phased implementation of Basel III, banks were required to raise their CAR to the minimum level of 11.9 percent (including capital conservation buffer of 1.9 percent) by end of CY18. ^[16] To comply with this requirement, several banks have enhanced additional Tier I capital through issuance of Basel III qualifying instruments (such as TFCs, Sukuk etc.) to the tune of PKR 37 billion in CY18 (PKR 8 billion in CY17). The tier II capital has slightly moved up due to revaluation of fixed assets and foreign exchange revaluation reserves. ^[17] The rise in retained earnings have also contributed to the overall increase in eligible capital of the banking sector, which has by 7.69 percent against 4.82 percent increase in total risk weighted assets leading to a higher CAR.

The bank-wise distribution of CAR reveals a strong solvency position as most of the banks have maintained CAR above 15 percent (Table 3.1.5). Further, the banks with higher CAR are mostly large and medium sized banks maintaining the bulk of the banking assets. 

Also, bank’s respond to tighter macrofinancial conditions by limiting the growth of Risk Weighted Assets (RWAs)…

Despite robust growth in lending activity (21.27 percent), the credit risk weighted assets have expanded at a slower pace of 10.67 percent (Chart 3.1.21).

This is because, banks have shifted lending portfolio from unrated exposures (attracting 100 percent or 125 percent risk weight) to rated categories with lower risk weights (20 percent and 50 percent) (Chart 3.1.22). Shifting exposures towards better rating categories is a welcome development from the risk management perspective as it indicates lower probability of default of corporate clients of the banks.

A considerable reduction in market risk weighted assets has further subdued the overall growth in RWA. The larger reduction in market risk weighted exposure has taken place against interest rate risk due to maturity of PIBs during the year. ^[18] Some erosion of banks’ exposure on equity investment has also reduced the market risk under this specific segment (Chart 3.1.23).

The operational risk weighted assets (ORWA) have shown steady growth, however. Since most of the banks are using Basic Indicator Approach (BIA), the annualized audited average gross income (of last three years) forms the basis for estimation of ORWAs. As such, this segment has remained the least volatile over time.

SBP has designated three large banks as D-SIBs…

To address the risks emerging from the cross sectional dimension of the systemic risk, SBP has issued a framework for Domestic Systemically Important Banks (D-SIBs) in April 2018. ^[19] Accordingly, SBP has designated three large banks as D-SIBs. These banks are required to meet enhanced supervisory and regulatory requirements, including the Higher Loss Absorbency Capital surcharge in the form of additional common equity tier-1 capital (CET1). Besides the designated D-SIBs, the branches of Global-Systemically Important Banks (G-SIBs) operating in Pakistan will hold additional CET1 capital against their risk-weighted assets in Pakistan at par with what is applicable on their respective G-SIBs. ^[20]

The banking sector of Pakistan has reasonable global standing in terms of financial soundness …

The cross-country data of financial soundness indicators reveals that Pakistan stands at a comfortable level in terms of solvency, liquidity and earnings (Table 3.1.6). However, despite consistently declining over time, its NPL ratio remains high compared to some of the AEs and EMDEs. However, new laws have been introduced in the last few years, which are expected to improve the debt recovery regime. ^[21] Further, net-NPLs to net-advances ratio stands at only 1.4 percent, indicating, low probability further equity erosion on account of credit risk.   

Banking infrastructure is steadily expanding…

The banking infrastructure and its growth pattern is a useful indication of the current as well as future growth prospects of the banks. The reviewed year has witnessed a broad-based and steady growth in the banking infrastructure i.e. brick and mortar based banks’ branches, ATMs, and electronic cards (Table 3.1.7). The increasing share of online branches overtime is also a welcome development, as it will improve banking efficiency.    

Future outlook

The banking outlook depends a lot on the future economic prospects and the corresponding policy responses. The monetary tightening towards the end of CY18 and first half of CY19 may lead to repricing of loans. This may improve the net interest income and, thus, profitability and solvency of the banking sector. On the other hand, it may dent the repayment capacity of the borrowers, thus, escalating the credit risk. Further, considering the contraction in LSM during July-March FY19 reflecting the dwindling performance of non-financial corporate sector, suggest that the odds of defaults are increasing.  Further, any downgrade of a sizeable portion of NPLs parked under “doubtful” and “substandard” categories could raise the provisioning expense for the banks. Thus, the credit risk remains paramount, going forward.

Besides implications arising from the realization of credit risk, the profitability of the banking sector depends upon the costs associated with mitigating the emerging operational risks and the interest rate dynamics. The mitigating measures against various risks such as compliance with AML/CFT related laws and regulations, fortifying systems against cyber-attacks, enhanced due diligence to ward-off fake/benami accounts, seeking legal remedies to manage challenges in overseas operations, etc. are all costly. The banks investment behavior in government securities and the interest earned there against are largely dependent on interest rate dynamics. Moreover, fiscal measures (such as super tax) has implications for the bank’s after-tax returns and solvency.

In order to meet the growing financing demand of public and private sector, banks need to renew their focus on deposit mobilization. The sizeable rise in MSR may help in restoring the deposit growth, though.

Like CY18, the enhanced CAR requirement (from current 11.9 percent to 12.5 percent) by the end of CY19, given slowdown in profitability, may compel banks may have to focus on raising capital through issuance of Basel III qualifying instruments. Banks, particularly small sized ones, will need to formulate concrete and time bound capital enhancement plans to meet their capital requirements. The strong NSFR and LCR of banks suggest that they will remain compliant with the Basel III liquidity requirements.

SBP, in cognizance of various emerging risks, has taken a number of regulatory and supervisory measures to mitigate their impact (See Box 2).

Box 4 FATF and AML/CFT Regime in Pakistan

Background

The Financial Action Task Force (FATF) is an inter-governmental policy-making body that was established in 1989 to help protect the integrity of the international financial system against misuses for money laundering and terrorist financing. The FATF has developed key recommendations to guide the countries on the development and implementation of effective Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) regimes in their jurisdictions. It also assesses the compliance of different jurisdictions with these recommendations and assesses the effectiveness of AML/CFT frameworks to identify any weaknesses. If a jurisdiction is identified as having strategic deficiencies in its AML/CFT regime, other jurisdictions and entities (which recognize the FATF’s Recommendations as the international standards) may enhance scrutiny and restrict trade and financial transactions with such identified jurisdiction. This move encourages the identified jurisdiction to plug the gaps and enhance compliance with the AML/CFT standards. Furthermore, FATF calls on its members to apply counter-measures against natural and legal persons from jurisdictions identified on FATF’s public statement as posing substantial ML/TF Risks to the global financial system.          

The FATF is supported by a network of FATF-Style Regional Bodies (FSRBs) in implementing and enforcing its Recommendations. The Asia/Pacific Group on Money Laundering (APG) is one such FSRB, which is an autonomous inter-governmental organization, consisting of 41 member jurisdictions, which ensures the effective implementation of these international standards. While Pakistan as such is not a member of the FATF, the country is associated with it through membership of the APG, since 2000. ^{[22] , [23]}

Placement on Grey-List

In June 2018, Pakistan was identified as a jurisdiction with strategic AML/ CFT deficiencies. ^[24] Pakistan has made a high-level political commitment to work with FATF and APG to implement an action plan to strengthen its AML/ CFT regime and address the strategic counter-terrorist financing-related deficiencies by demonstrating that: ^[25]

• terrorism financing (TF) risks are properly identified and assessed, coordination on TF risks is improving, and law enforcement agencies (LEAs) are investigating the widest range of TF activity

• TF prosecutions result in effective, proportionate and dissuasive sanctions, and that the capacity and support for prosecutors and the judiciary has been enhanced;

• remedial actions and sanctions are applied in cases of AML/ CFT violations;

• enforcement action is being taken against illegal money or value transfer services (MVTS);

• authorities are identifying cash couriers and enforcing controls on illicit movement of currency;

• targeted financial sanctions are being effectively implemented (including enforcement actions against violations); and

• facilities and services owned or controlled by designated persons are deprived of their resources and the usage of the resources. 

• Pakistan is working to implement the action plan by September 2019 to negotiate an exit from the “grey-list’. In the interim, the FATF’s International Cooperation Review Group (ICRG) and APG have been holding a series of meetings with Pakistani representatives to monitor Pakistan’s progress vis-à-vis the action plan.

Pakistan’s AML/CFT Regime

Pakistani authorities give high importance to the effectiveness of AML/CFT regime. In this regard, SBP is taking initiatives, on regular basis, for strengthening the overall AML/CFT regime. SBP introduced AML/ CFT Policy Framework for its regulated institutions in 1990s and over the years, it has been strengthened in the light of emerging best practices.

The AML law in the country was promulgated in 2007, which defines the legal obligations in respect of money laundering and terrorist financing, and enjoins the roles and powers of different stakeholders and law enforcement agencies. To facilitate implementation of the law, a full-fledged Financial Monitoring Unit (a financial intelligence unit) receives  suspicious transactions reports (STRs) and currency transactions reports (CTR) from different reporting entities and (after due analysis) refers the potential cases of money laundering and terrorist financing to the respective investigation agencies in the form financial intelligence for further examination/ investigation and prosecution.

While Pakistan’s legal and regulatory framework is quite comprehensive, the country is currently working on further enhancing the effectiveness of the AML/ CFT regime. The country has recently taken a number of significant measures and initiatives to further strengthen the AML/ CFT framework. In this regard, SBP has issued or strengthened the following set of guidelines and instructions to its regulatees:  

-To align AML/CFT Regulations with the Financial Action Task Force (FATF) Recommendations, various provisions of the regulations have been ended to provide further clarity on requirements relating to customer due diligence (CDD), correspondent banking, wire transfers/ funds transfers and minimum documents required for opening accounts by customers. ^[26]

-For strict compliance of Statutory Regulatory Orders (SROs) and Notifications issued by the Government of Pakistan under the United Nations (Security Council) Act, 1948 and Anti-Terrorism Act (ATA), 1997, detailed guidelines for ECs have been issued on Targeted Financial Sanctions (TFS) for prevention of Terrorism Financing and Proliferation Financing under UNSC Act, 1948 and ATA, 1997. ^[27]

-Banks have been advised that sponsor shareholders/beneficial owners, directors, Presidents and key executives (persons subject to FPT) will become disqualified if they are designated/proscribed or associated directly or indirectly with designated/proscribed entities/persons under United Nations Security Council Resolution or Anti-Terrorism Act 1997. ^[28]

 

-Enhanced the scope of Know Your Customer (KYC) standards and documentation requirements for ECs. ^[29]

 

SECP and other bodies have issued the following set of instructions and guidelines for strengthening AML/CFT for entities in the non-bank financial sector and other corporate entities:

-Associations with Charitable and Not for Profit Objects Regulations, 2018 have been issued to specify procedures to grant licenses to associations with charitable and not for profit objectives, incorporation of association as a public limited company, fit and proper criteria, provision for revocation of license and winding up, and monthly reporting requirements.

-AML/CFT Regulations, 2018 have been issued to provide a consolidated set of regulations for financial institutions under the ambit of the SECP including Modarabas, Insurers, Non-Bank Financial Companies (NBFCs), etc. to harmonize the AML/ CFT regime. The Regulations have adopted a risk-based approach towards combating ML/TF, and are focused on high risk areas including politically exposed persons, legal persons, legal arrangements with complex ownership structures, etc.  –

-Anti Money Laundering and Countering Financing of Terrorism Regulations, 2018 have been amended to bring further clarity on various aspects including beneficial ownership, legal persons, Counter-measures against high risk countries, etc.

-AML & CFT Guidelines for Real Estate Agents 2018 have issued to bring the real estate agent into the regulatory ambit of AML/ CFT regime. The guidelines recommend complying with AML laws/ regulations while reporting Suspicious Transactions and Cash Transactions, implementing CDD measures, keeping proper records, etc.

Pakistan Post, being a saving bank and money transfer services provider to the general public, has issued AML/CFT Regulations in October 2018 to deter the risks of money laundering and financing of terrorism. Similarly, the designated non-financial business and professions (DNFBPs) such as real estate agents, charities, jewelers, etc. have been brought under the ambit of AML/CFT regime.

From the implementation perspective, regulatory bodies and other government entities are taking measures for effective enforcement of the AML/CFT related regulation. SBP is strictly enforcing its regulations and instructions and is taking penal actions against such regulated institutions, which have been found delinquent during the supervisory process. These institutions have also taken disciplinary actions against concerned employees including issuing reprimands, incremental stoppage, etc.

Similarly, the Federal Board of Revenue (FBR) has taken extensive measures to counter illicit movement of currency ^[30]These measures include launch of an extensive risk mitigation strategy to curb cash smuggling, increased currency seizures, implementation of Currency Declaration Systems (CDS) at international entry/ exit points, etc.

Overall, Pakistan’s AML/ CFT regime has further improved during the period under review. Presently, adequate legal and technical infrastructure is in place and the government is highly committed to address any remaining deficiencies in the AML/CFT regime. It is hoped that these enabling factors coupled with ongoing efforts to enhance the capacities of relevant agencies as well as strengthen inter-agency cooperation will help to deliver on the action plan and address those strategic deficiencies.

 

 

^[1] The 16^th and 17^th waves of Business Confidence Index Survey (BSI) conducted by Overseas Investor Chamber of Commerce (OCCI) in May and December 2018, respectively, showed a significant decline in the overall business confidence Score (BCS) in both waves of the surveys. Similarly, SBP Business Confidence Survey also indicates the deterioration in business confidence during Aug-18 (i.e. first published survey) and April-19.

^{[2] [2]} Due to excess liquidity, (a) the average deviation between ONR and SBP policy rate has been only 0.003 bps in CY18 compared to 6.36 bps in CY17, (b) weekly data shows higher average (1.22 trillion) outstanding stock of cash and banks’ balance with other banks (including treasury bank) in CY18 compared to CY17 (1.09 trillion). 

^[3] The average monthly spread between weighted average lending rates (excluding zero markup and interbank) on fresh advances and weighted average deposit rates (including zero markup and excluding interbank) on fresh deposit has reduced from 4.13 percent in CY17 to 4.08 percent in CY18 (http://www.sbp.org.pk/ecodata/

Lendingdepositrates.pdf).

^[4] Source: The State of the Pakistan’s Economy: First Quarterly Report FY19

 

(http://www.sbp.org.pk/reports/

quarterly/fy19/First/Chap-3.pdf)

^[5] SBP estimates based on Vector Autoregressive (VAR) models.

^[6] Systemic risk refers to a widespread disruption to the provision of financial services due to partial or full impairment of the system that might have serious negative implications for the real economy. It has two major component; (a) pro-cyclical systemic risk: the vulnerabilities built up over time and (b) structural systemic risk: vulnerabilities arising from interconnectedness and distribution of risk within the financial system at a point in time.

^[7] As per IMF-BIS-FSB, if banks are significant providers of credit to the economy, systemic risk typically surround the banking system.

https://www.imf.org/external/np/pp/

eng/2014/110614b.pdf

^[8] Table 3.11, “Classification of Scheduled Banks' Advances by Securities Pledged”, SBP Statistical Bulletin, February 2019

(http://www.sbp.org.pk/reports/

stat_reviews/Bulletin/

2019/Feb/BankingSystem.pdf)

^[9] For example, Basel III capital and liquidity standards.

^[10] The minimum rate on saving deposits is directly linked to SBP repo rate (i.e. floor of the SBP interest rate corridor). As the monetary policy tightens, the MSR rises.

^[11] About 41.6 percent of the deposits are of very large size (PKR 10 million and above).

^[12] The interconnectedness is measured by two major indicators i.e. (1) interbank call borrowing plus call lending and (2) Other interbank financial liabilities plus assets: total borrowings and interbank lending plus total deposits (financial institution) minus call borrowings minus repo borrowings from SBP minus call lending. 

^[13] Source: Bloomberg

^[14] Liquid assets are consist of (a) cash and due from treasury banks, (b) balance with other banks, (c) call money lending, (d) reverse repos lending and (e) all government securities.

^[15] Though, extra ordinary items expenses in CY18 (PKR 9.0 billion) are less than CY17 (PKR 23.7 billion), they are still significantly higher than their historical trend. 

^[16] Banks are required to raise their CAR at 12.5 percent by end CY19. BPRD Circular No.6 of 2013 (http://www.sbp.org.pk/bprd/2013/C6.htm)

^[17] However, yearly flows of overall revaluation reserves turned into negative due to revelation deficit on AFS securities.

^[18] The instrument of longer maturity attract higher market risk weight under Basel instructions for capital adequacy calculation.

^[19] The framework follows two steps approach; in first step, a sample of banks based on quantitative and qualitative criteria is identified. In the second step, among these sample banks, D-SIBs are designated based on Size, Interconnectedness, Substitutability and Complexity.

^[20] http://www.sbp.org.pk/press/2018/Pr-14-Jun-18.pdf

^[21] For example, Financial Institutions (Recovery of Finances) (Amendment) Act 2016, Corporate Restructuring Companies Act 2016, Financial Institutions Secured Transaction Act 2016 and Corporate Rehabilitation Act 2018.

^[22] http://www.apgml.org/about-us/page.aspx?p=91ce25ec-db8a-424c-9018-8bd1f6869162

^[23] http://www.fatf-gafi.org/pages/

asiapacificgrouponmoneylaunderingapg.html

^[24] http://www.fatf-gafi.org/countries/d-i/iraq/documents/fatf-compliance-june-2018.html

^[25] https://www.fatf-gafi.org/publications/high-riskandnon-cooperativejurisdictions/documents/fatf-compliance-june-2018.html

^[26] BPRD Circular Letter No. 16 of 2018

^[27] FE Circular No. 09 of 2018

^[28] BPRD Circular No. 09 of 2018

^[29] EPD Circular Letter No. 08 of 2018

^[30] https://fbr.gov.pk/pr/effective-steps-taken-by-fbr-customs-operatio/132037

---

 

3.2 Performance and Risk Analysis of the Islamic Banking Industry

While global banking sector has seen deceleration, Islamic Banking Institutions (IBIs) in Pakistan have shown healthy growth of 17 percent. In the domestic context, the growth in assets of IBIs has outpaced those of the conventional banks, mainly due to surge in financing. IBIs have improved the diversity in Shariah modes of financing, particularly in Profit and loss sharing modes. Most of the increase in financing is funded by strong growth in deposits. Improved asset quality and rise in profitability have enhanced the soundness and stability of IBIs. Liquidity deployment in the short term remains the key challenge faced by the IBIs, while need remains for improving the suit of products for increasing financing to SME and agriculture sector.

 

The global Islamic Financial Services Industry (IFSI) is decelerating…

On the Global landscape, Islamic Financial Services Industry’s (IFSI) assets crossed the landmark of USD 2 trillion and reached USD 2.19 trillion at the end of June, 2018 compared to USD 1.89 trillion at the end of June, 2017. ^[1] The growth has been recorded in all the three sectors i.e. Islamic Capital Markets, Takaful and Islamic Banking. However, the pace of overall growth in dollar value of IFSIs has slowed down (6.9 percent during Jul, 17-Jun, 18 versus 8.5 percent during Jul,16-Jun,17) mainly because of exchange rate depreciation in various jurisdictions. The IFSI has remained sound and stable, despite emergence of various risks including continued trade tensions, inflation and foreign exchange exposures.     

Among the IFSIs, the global Islamic banking assets hold around 70 percent share. However, the growth in the assets of Islamic banks has decelerated to 4.16 percent during CY18 compared to 10.03 percent increase in CY17 (Table 3.2.1). ^[2]  

In tandem with assets deceleration, growth in Shariah compliant financing has also slowed down to 3.09 percent in CY18 as compared to 8.95 percent in CY17. The asset quality of global Islamic banks, on an aggregate level, has somewhat strengthened

The profitability of the global Islamic banking industry seen marginal decline over the year. The ROA marginally declined to 1.86 percent during CY18 from 1.92 percent in CY17, while ROE has declined by 124 bps to 15.62 percent in CY18. ^[3] Further, the CAR of Islamic banking industry has remained strong at 12.3 percent, which is well above the international benchmark of 10.5 percent. Similarly, Islamic banking sector of most of the jurisdictions have robust capital positions.

 

Despite tightening of domestic macrofinancial conditions, IBIs have outpaced conventional banks in their asset expansion…

The assets of domestic IBIs have continued to grow in CY18, relatively faster than their conventional counterparts, but at a slower pace than the last year owing to growing macroeconomic challenges (Table 3.2.2). The assets of IBIs have increased by 17.02 percent during CY18 (22.60 percent in CY17), as opposed to the growth in assets of conventional banks of 5.94 percent. This has mainly been due to significant increase in financing.

As a result, the share of Shariah compliant banking assets in the total banking assets has increased to 13.51 percent in CY18 compared to 12.39 percent in CY17.

Financing has increased rapidly …

As opposed to 21.46 percent growth in advances of conventional banks, the IBIs’ financing has increased by 25.20 percent during CY18. Resultantly, the share of Shariah compliant financing in total advances has increased to 18.99 percent in CY18 (18.53 percent in CY17 and 9.19 percent in CY14). This expansion has contributed to around 80 percent in the growth of total assets of the IBIs.

The relatively better financial intermediation by IBIs could be due to higher preference of customers for Shariah-compliant products, availability of low cost funding, and a better credit risk assessment. Besides, lack of Shariah compliant investment opportunities is encouraging IBIs to focus more on their core financing activities. As a result, there is high growth in financing backed by the reasonable increase in deposits. The financing to deposit ratio of IBIs have increased to 68.58 percent in CY18 from 64.02 percent in CY17.

……

Private sector financing has maintained healthy growth over the years with another 32.27 percent rise in CY18 in comparison to 24.93 percent in CY17 (Chart 3.2.1). In tandem with the private sector, the share of public sector financing has also been increasing mainly because of commodity operations. The major portion i.e. 98.69 percent is outstanding against wheat financing. However, the financing entails no credit risk as the repayment is guaranteed by the government department(s).

… while diversity in financing continues to grow … 

IBIs are extending financing under three broader modes i.e. Trade based, Lease based, and Profit and Loss sharing based. There are various Shariah compliant products within each mode to cater for the diverse credit needs of the individuals and institutional borrowers. Over the years, the profit and loss sharing modes of financing have observed increased share in the overall financing. The share of Musharaka and Diminishing Musharaka has increased from 43.6 percent in CY14 to 53 percent in CY18.

Within the various  modes of financing, Diminishing Musharaka represents 1/3^rd of the total financing during CY18 (Table 3.2.3). While the share remains high, the concentration in this particular mode is not alarming as it offers diverse range of financing product backed by tangible assets including machinery, construction of storage facility/ sheds/commercial or residential buildings etc.

Corporate sector remains major borrower…

In terms of segment-wise financing, the IBIs have served the corporates more than any other segment (88.96 percent of net financing in CY18). This is despite some deceleration in corporate financing (31.02 percent growth in CY18 versus 32.64 percent in CY17) (Table 3.2.4).

However, sectoral analysis reveals that the financing is well diversified. The largest user of the Islamic financing is the energy sector with the share of 17.70 percent in total financing in CY18 followed by textile (12.97 percent) and individuals ^[4] (11.42 percent) (Chart 3.2.2). During CY18, the highest growth of 34.84 percent has been registered in energy sector followed by individuals (29.27 percent) and textile (23.91 percent).  

Despite marginal slowdown in Islamic corporate financing, the share of the same in total corporate financing has risen to 18.98 percent in CY18 from 18.09 percent in CY17.

…while share of financing to SMEs and agriculture remains low…

The financing to SMEs has witnessed exponential growth over the last few years. SME financing has increased by 40.64 percent in CY18 (39.96 percent in CY17). The rise in SME financing can be attributed, among others, to indicative financing targets advised by SBP. ^[5] The outstanding SME Islamic financing has increased from PKR 29 billion in CY16 to PKR 57 billion in CY18. Accordingly, the share of IBIs in overall SME financing has increased to 11.32 percent in CY18 from 7.18 percent in CY16. However, the share of SME financing in total Islamic finance portfolio remain low at 3.71 percent.

Agriculture is the key contributor to the GDP of Pakistan. However, Agri-finance have less than 0.5 percent share in IBIs financing and is lagging behind 5 percent share in conventional banks’ lending. Even the share of Islamic agriculture financing in overall agriculture financing has declined to 1.55 percent to CY18 from 1.77 percent a year earlier. While SBP has issued detailed guidelines on Islamic financing for agriculture, IBIs are still to utilize the available regulatory framework for venturing into and enhancing agricultural financing.

Healthy growth improved the share of Islamic Consumer Finance…

On the other hand, the share of Islamic consumer financing in total financing has risen to 29.05 percent in CY18 from 27.23 percent in CY17. The overall growth in consumer financing has been 19.40 percent in CY18 compared to 20.62 percent in CY17 (Chart 3.2.3). Despite this deceleration, Islamic consumer financing contributes to 38.43 percent in overall growth of consumer financing. Within this particular segment, IBIs encompass 47.15 percent and 54.56 percent share in overall auto and house financing, respectively. This growth has mainly resulted from these modes being asset backed (Ijara for Auto finance and Diminishing Musharaka for housing finance) and consumer preference for the Islamic mode of consumer financing over the conventional financing.

The asset quality of IBIs has improved, suggesting lower credit risk…

(Chart 3.2.4). The provision coverage is at a comfortable level as it has increased to 83.20 percent in CY18 from 82.51 percent a year earlier. The improvement in the asset quality indicators despite the increase in policy rate and macro-economic vulnerabilities indicates, to some extent, better credit quality management at IBIs.

The dearth of Sharia compliant investment opportunities routes IBIs focus towards financing…

Due to dearth of Sharia compliant investment opportunities, investment portfolio of IBIs has decreased by 3.35 percent in CY18 in contrast to an increase of 9.14 percent in CY17. The share of investments in total assets of IBIs is 19.37 percent, which is 43.46 percent in conventional banks. This has nudged IBIs to expand their intermediation function through higher financing leading to more profitability.

Further, analysis reveals that GoP Sukuk dominates the investment portfolio of IBIs with 59.71 percent share (Chart 3.2.5). Due to net maturity of GoP Sukuk, the share of corporate Sukuk in total investment portfolio has risen to 23.04 percent in CY18 from 19.58 percent in CY17.

Deposits have provided needed funding for asset expansion…

Deposits are the mainstay of funding for the IBIs. Though deposit growth has decelerated to 16.87 percent in CY18 compared to 19.81 percent in CY17, they have funded 82.21 percent growth of total assets during CY18. Both the savings and current deposits, have witnessed deceleration in growth. Fixed deposits, on the other hand, have surged by 24.09 percent in CY18 compared to 10.41 percent in CY17 (Chart 3.2.6).

The growth in fixed deposits is quite substantial as it accounts for 67.44 percent addition in total fixed deposits of all banks. It seems that with growing financing to deposit ratio IBIs have a) increased mobilization of fixed deposit, in an increasing interest rate environment and at a relatively lower cost than the conventional banks ^[6] ; and b)opted to mobilizing long-term deposits to improve their maturity profile; IBIs have mostly mobilized deposits with maturity above 3 years. The latter aspects has helped IBIs in improving the overall maturity gap due to improvement in financing flow and compositional change in the deposit profile. (Chart 3.2.7).

The scarcity of short-term investment instruments for deployment of funds has remained a key issue for IBIs. Due to net maturities of GoP sukuk during CY18, liquid assets have declined by 2.98 percent to PKR 596 billion. As a result, liquid assets to total assets has seen considerable decline to 22.41 percent over a year. Further, IBIs have kept 27.83 percent of their liquid assets in the form of “cash, balances with other banks and lending to financial institutions” compared to 16.59 percent in case of conventional banks (Chart 3.2.8). However, IBIs liquidity remain in a comfortable zone as the Statutory Liquidity Requirement (SLR) for IBIs stands at 14 percent against the requirement of 19 percent for the conventional banks.

Low borrowings entail limited funding risk…

Contrary to conventional banks reliance on borrowings (12.73 percent), IBIs have funded 6.23 percent of their total assets through borrowing on average. ^[7] Lack of Shariah compliant instruments in interbank market also restricts the borrowing of IBIs which may lead to funding risk in short-term. As such, IBIs are more dependent on deposits to finance their assets.

Within the secured borrowing, Islamic export refinance is 44.32 percent of the total borrowings. With the introduction of three different Islamic financing facilities, for Modernization of SMEs, Storage of Agricultural produce, Renewable energy, and financing facility for low cost housing for special segments, it is expected that these secured borrowing facilities from SBP might increase Islamic financing in above focused areas in the future.

IBI’…

The profitability of the IBIs has improved significantly over the year. The profit (after tax) at PKR 24.88 billion has registered an increase of 51.31 percent in during CY18. (Chart 3.2.9). Resultantly, the after-tax Return on Assets (ROA) has improved to 1.02 percent in CY18 from 0.81 percent in CY17. Improvement in earning has, mainly, resulted from 29.95 percent increase in net markup income during CY18. Analysis of the components shows that most of this growth in net markup income has been contributed by 44.42 percent rise in markup income from financing activity, while mark-up expense increased by 35 percent.

…which strengthens the solvency profile of IBIs

Driven by high profitability, the solvency of the IBIs has strengthened. CAR has improved to 14.04 percent in CY18 from 13.06 percent inCY17 (Chart 3.2.10), which is well above the regulatory requirement. The improvement can be attributed to increase in the unremitted profit by PKR 17 billion (44.00 percent) in CY18 and dilution of CRWAs due to increase in public sector financing. Despite some improvement, the CAR of IBIs has remained below the conventional banks, primarily, due to high share of financing in total assets.

In addition to the risk confronted by the conventional banks, IBIs are exposed to Shariah non-compliance risk arising from their failure to comply with the Shariah standards. SBP, cognizant of this risk, has put in place a detailed Sharia Governance Framework for IBIs. ^[8] In addition, it has advised IBIs to undertake enhanced measures for training and capacity building of their staff. ^[9]

The Islamic banking industry has continued its impressive growth in CY18. Besides IBIs own efforts, the conducive operating environment provided by SBP has also been an important factor. SBP’s efforts in promoting Islamic Banking in Pakistan have been recognized internationally. It has been presented with a global award as the best Central Bank in promoting Islamic finance for the year 2018. The award is conferred by the Islamic Finance News (IFN), an arm of RED money Group, Malaysia.

The IBIs have showed interest in SME financing, which will give impetus to economic growth due to its strong economic interlinkages of SMEs. However, at the same time, it may increase the credit risk of IBIs if credit risk management is compromised. For further product diversification and enhancing contribution in the economic growth, IBIs needs to explore new business opportunities in the low cost housing and enhance financing to agriculture segment.

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Islamic Financial Services Board (IFSB), 2019. Islamic Financial Services Industry Stability Report 2019. Available at: https://www.ifsb.org/download.php?id=5231&lang=English&pg=/sec03.php

^[2] Islamic Financial Services Board (2018). Islamic Financial Services Industry Stability Report 2018. [online] Kuala Lumpur: Islamic Financial Services Board. Available at: https://www.ifsb.org/download.php?id=4811&lang=English&pg=/sec03.php [Accessed 27 Feb. 2019].

^[3] IFSB Key Exhibits available at: https://www.ifsb.org/psifi_02.php?selfolder=

^[4] Individual includes financing to consumer, sole proprietorships, and any business owned by single individual, irrespective of the size of its operations.

^[5] As per “Policy for promotion of SME Finance”, SBP assigned SME financing targets to banks and DFIs for the first time in 2016 in order to enhance access to credit to this sector. SBP is targeting SME financing to reach 17 percent of total private sector credit by the end of 2020. Currently, SME financing is at 6.2 percent of the total private sector credit. Therefore, SME credit is expected to grow significantly in the years ahead.

^[6] SBP has issued Minimum Saving Rate (MSR) Policy for banks in terms of which are required to remunerate the saving deposits at least at 50bps below the floor of the interest rate corridor. However, keeping in view the Sharia Laws, SBP exempted IBIs to observe the Minimum Saving Rate on deposits vide BPRD Circular No. 7 of 2008..

^[7] IBIs have funded, on an average, 6.23 percent of their assets through borrowings in CY 18 compared to 5.35 percent of their assets in CY17.

^[8] IBD Circular No. 01 of 2018 available at: http://www.sbp.org.pk/ibd/2018/C1.htm

^[9] IBD Circular No. 02 of 2018 available at: http://www.sbp.org.pk/ibd/2018/C2.htm

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3.3 Resilience of the Banking Sector under Stress Scenarios

The stress scenario is not a forecast of macroeconomic and financial conditions. It is a hypothetical but coherent tail-risk setting designed specifically to assess the resilience of the banking sector to potential deterioration in macroeconomic conditions. This years stress testing exercise assesses the extent to which the banking sector is able to withstand hypothetically designed domestic and global shocks in the medium term, besides considering the business as usual conditions in the baseline. Given the existing vulnerabilities, under the baseline scenario, the sector’s current level of solvency may deteriorate moderately yet it will remains well above the domestic regulatory benchmark. Under the hypothetical shock scenarios, however, the banking sector can withstand for three years the severe and protracted downturn induced by adverse global macroeconomic conditions. In terms of size, all categories of banks can withstand the stress conditions as well. Reassuringly, the large size banks with potential to cause systemic disruptions carry sufficiently higher capital buffers and are able to sustain the impact of hypothesized shocks for around four years. The resilience of medium sized banks, however, may come under stress after three years, while small size banks continue to meet solvency criteria during the projection horizon of five years. Encouragingly, the banking system with adequate capital buffers can cater to the credit needs of the economy even during stress periods, albeit at a slower pace.

 

3.3.1 Background and Developments

The feedback effects between the real and financial sectors, where vulnerabilities in one sector spillover to the other, have been most prominently highlighted by the onset of global financial crises (GFC) of 2007-08. Since then, the regulators and supervisors have enhanced the level of financial sector oversight, thereby emphasizing on its resilience to withstand shocks transmitting from the rest of the economy. At the same time, stress-testing framework is also being extensively used by the domestic authorities as well as multilateral agencies to assess the resilience of the banking sector to certain hypothetically designed adverse yet plausible event(s). The results of stress-tests, therefore, depict the projected behavior of macro-financial variables and health of the banking sector under the assumed scenarios.

The SBP has been conducting this exercise internally on a quarterly basis since 2005 while for the external stakeholders, the stress-testing results are being published in the FSRs since 2007-08. The stress-testing framework, while still in its evolutionary phase, is continuously being revamped and strengthened over the recent years.

The current year’s stress testing exercise includes three separate scenarios, designed to assess the health of the banking sector over the medium term, i.e. five years from Q1CY19 to Q4CY23.

The baseline scenario traces the path of macro-financial variables under the current dynamics of the domestic macro-economy, i.e., business as usual. The other two scenarios, domestic and global, on the other hand, assume crystallization of idiosyncratic and systemic shocks, such as natural disasters and disruptions in global economy, and project their impact on the resilience of the banking sector. Of the latter two stress scenarios, global has been designed to be severer. ^[1]

The methodology used to evaluate the resilience of banking sector in all the three scenarios is similar but differs in terms of paths being followed by the macroeconomic variables. Given the interaction between various sectors of the economy, a number of variants of vector autoregressive (VAR) models have been employed. ^{[2] , [3]}  In addition, the cross-sectional heterogeneity has been captured by including segments of banking industry in terms of size (i.e., small, medium, large).

3.3.2 Scenario Design Overview

The baseline scenario assumes business as usual environment, both globally and domestically, and is based on recent macroeconomic developments. The domestic scenario has been constructed to assess vulnerability of the banking sector to risks emanating from agrarian nature of domestic economy. These risks include catastrophic events generally attributed to climate change and, disruption in river flows due to rising geopolitical tensions. The global scenario focuses upon implications of slowdown in key trading partner economies, down grading by Financial Action Task Force (FATF), volatile oil prices and stabilization measures taken post- anticipated IMF program.

The implications of changes in macroeconomic indicators; such as output, inflation, exchange rate, interest rate and  exports, on the health of the banking sector have been captured via non-performing loans, profitability and solvency. Specifically, the economic downturns can negatively influence the income levels of borrowers and affect their debt servicing capacity, thereby amplifying the credit risk for banks. This in turn would put adverse pressures on the profitability of banks, thus negatively affecting their solvency.

Given the feedbacks, the solvency issues in banking sector could spill over to the real economy as the banks would be reluctant to provide credit to even potentially profitable investment opportunities, amplifying the downturn. The sharp deceleration in credit flows by the banks during the downturns, could further slowdown the pace of economic growth.

Stress test models, designed to test banking industry’s resilience against adverse shocks, capture these inter-linkages among the various sectors of the macro economy. The monetary authority’s feedback reactions, in response to the shocks, are assumed to reflect in the interest rate adjustments.

In terms of risk coverage, the resilience of the banking sector has been assessed against credit, market (interest rate and exchange rate) and operational risks.

Baseline Scenario

The baseline scenario, Scenario 0, assumes absence of any idiosyncratic or systemic shocks over the simulation period. However, in 2018, domestic economy has experienced rise in inflation and downward adjustment in value of currency; ^[4] primarily owing to challenges on fiscal and external accounts. Policy makers have countered this situation by contractionary monetary and fiscal policies. ^[5] Owing to these stabilization measures, uncertainties surround the short run growth prospects. Considering these developments, international observers, e.g., IMF, are also expecting lower growth trajectory (Chart 3.3.1). ^[6]

In the medium run, adoption of contractionary monetary and fiscal policies is expected to tame inflationary pressure; albeit at the cost of economic activity. On the other hand, adjustment in exchange rate is expected to support current account deficit by rationalizing imports demand and boosting exports. So far as the oil prices are concerned, Scenario 0, assumes prices to remain in the range of USD 55-60 per barrel; which is consistent with medium term projections based on oil futures. ^[7]

Domestic Scenario

The agriculture sector remains one of the important component of domestic economy. Though its share is slowly declining, the sector’s output accounts for around one-fifth of the total GDP. Further, its interlinkages with industry and services sectors make it an important driver of the economic growth. Naturally, the sector remains prone to climate change and natural calamities such as periodic floods and droughts. Such shocks, in the past, have led to periods of low growth, surging inflation and reduced productive capacity in the economy.

Global warming and the consequent climate change have been postulated to lead to extreme weather conditions causing droughts, floods, famine and cyclones. According to Long-Term Climate Risk Index (CRI) 2019, during last two decades, Pakistan experienced 145 climate related events and remains 8^th most affected country in terms of human and output losses.

The domestic stress scenario, Scenario 1, of the current exercise is largely similar to the previous year’s design, as discussed earlier. However, some adjustments have been made so that the scenario remains relevant and plausible. It considers the effects of climate change, particularly water shortage, on the agriculture sector, overall economy and ultimately the banking sector. The less availability of water is assumed to mainly stem from reduced rainfall, lower river flows, ^[8] less snowfall and depletion of glaciers due to extreme temperatures. Additionally, the scenario is also motivated by the recently escalated geopolitical tensions and potential threats of water blockage. Such climate change and geopolitical risks may raise concerns about water conditions and its availability in the medium term.

In this context, the basis of shock design stands on the footprints of 1999-2001 drought, one of the longest and worst episodes of droughts (Chart 3.3.2). ^[9] A substantial fall in agriculture output, mainly due to crops failure, is therefore assumed and the domestic economic growth contracts to 2 percent for initial two years and recovers to around 3 percent by the end of the scenario.

The assumed crop failure may prompt the government to provide post-disaster relief packages, pushing current expenditure up and worsening the fiscal position. 

With a drop in agriculture output, it is assumed that agri-exports, which constitute around 17 percent of total exports in December 2018, would fall. ^[10] Non-agriculture exports, which use agriculture produce as raw materials, would also be hampered. Overall, the exports would decline before rising back by the end of scenario. The imports of raw materials and food could also rise, which in turn would further aggravate country’s current account balance.

The PKR/USD parity may also weaken, leading to cost-push inflationary pressures. Given low domestic savings - lowest among peer countries - the severity of the shock may amplify. ^[11]

The expected water shortages could also weigh significantly on the hydropower generation, which, during Jul-Feb FY18, constituted around 27 percent of total electricity generation. ^[12] The stressed energy conditions may depress the industrial production and domestic investments, causing a drop in overall output. The supply shock may further intensify the price pressures as well.

To meet the shortfall, among other alternatives, thermal sources of power generation is expected to be pushed further. However, such a remedy may lead to higher import of oil and coal, thus amplifying the already high import bill. Besides pressures on the external account, the situation would result in higher prices, mainly via pass-through to consumer goods. Headline inflation is, thus expected to reach as high as 14 percent before falling back to 8 percent during the projection horizon. In response to these vulnerabilities, appropriate adjustments in interest rates is also presumed to check inflationary expectations.

The growth paths considered in this scenario for various macro-financial variables are projected through the same feedback models used in Scenario 0.

Global Scenario

This years’ global scenario incorporates four key global risks. These risks include the decline in world economic growth, escalations of trade tensions among major economies, volatile oil prices and potential downgrading of Pakistan from grey-list by FATF. The scenario (Scenario 2), designed to assess the capability of the domestic banking sector to withstand simultaneous materialization of the above mentioned downside risks, portrays a considerably extreme but plausible set of events.

The IMF, in its latest issue of WEO April 2019, estimates Pakistan economy to grow by 2.9, 2.8 and 2.5 percent in 2019, 2020 and 2021, respectively. While, it estimates the world GDP growth for 2018 to slightly taper and tick in at 3.6 percent. ^[13] Moreover, forecasts of world GDP growth for 2019 and 2020 are revised downward by 40 and 10 basis points to 3.3 and 3.6 percent, respectively. One of the key factors behind slowdown of global growth is US-China trade tensions. Scenario 2 assumes intensification of these trade tensions, which may detract ongoing recovery of global financial markets.

Apart from general recessionary impact of trade tensions, downsides include uncertainty regarding no-deal Brexit in UK, geopolitical tensions in Middle East and larger than anticipated slowdown in these economies. If materialized, these risks may negatively affect exports and remittances related flows to Pakistan economy. ^[14]

International observers are foreseeing oil prices to stay around USD 55 per barrel in the medium run. ^[15] Despite this stable and low outlook for oil prices, risk of resurgence in prices exists and explains the recent rise in oil prices. ^[16] For instance, OPEC member countries and Russia have been trying to cut oil production in response to prolonged low oil prices, which are not viable for most of the oil producing countries. ^[17] Further, the effective materialization of US imposed sanctions on oil exports from Iran might beget the rise in oil prices at a higher pace. ^[18] Accordingly, Scenario 2 assumes oil prices to reach USD 80 per barrel before stabilizing at USD 75 per barrel during the last year of projection period.

Under Scenario 2, the above global risk factors will accentuate the domestic economic vulnerabilities, especially the twin deficits. Keeping in view the above facts, our global scenario also assumes that the fiscal and BoP vulnerabilities would necessitate support from IMF. However, IMF programs typically accompany macroeconomic consolidation measures, including a floor on net foreign assets (NFA) and a ceiling on net domestic assets (NDA). As a result, exchange rate depreciation and upward adjustment in utility prices may be anticipated. Further, with a ceiling on NDA in place, the government generally turns towards scheduled banks to finance budget deficit, which may crowd out private sector investment during initial phase of macroeconomic consolidation. However, as the consolidation efforts bear fruits and economy stabilizes, fundamentals are likely to improve, albeit gradually, during the second half of our projection period.

Amid these anticipated developments and recovery, this scenario design assumes a U-shaped trajectory, with a sharp initial deterioration, followed by gradual recovery towards end of the projection period.

In line with global dynamics, Scenario 2 assumes that real GDP growth may decline to below one percent; leading to significant slowdown in exports and remittances. Resulting pressure on external account is expected to weaken PKR/USD parity; causing imports to be more expensive and resulting in buildup of significant domestic price pressures.

In view of the assumed inflationary and exchange rate pressures, an appropriate policy response may be required. Particularly monetary authority may appropriately adjust the benchmark interest rates. Therefore, the assumed external sector pressures, a slowdown of aggregate demand and tighter monetary conditions, would translate into elevated levels of credit risk, leading to higher infections and some brake on bank lending. The slowdown in lending activity may also hurt the interest income of banks. This, coupled with higher provisioning expenses, could possibly impair banking industry’s profitability and ultimately the capital adequacy.

3.3.3 Stress Testing Results: System Level

(a)     Impact on Credit Riskiness

The results of stress test exercise indicate that gross non-performing loans ratio (GNPLR), under Scenario 0, is likely to remain somewhat elevated over the five year projection horizon, given the domestic and external pressures (Chart 3.3.6). Over the initial two years of projection horizon, GNPLR may rise to 11.54 percent and would settle at the level of 13.07 percent by the end of projection period, which is 5.16 percentage points higher than 7.91 percent as of end 2018. This is mainly in line with our assessment of the domestic economy, where existing macro-economic vulnerabilities may cause a moderate level surge in NPLs of the banking sector.

Scenario 2) as delinquency rate touches 23.64 percent by the end of projection horizon. In response to domestic shocks (Scenario 1), on the other hand, delinquency reaches to 21.10 percent. Credit risk under both stress scenarios are higher than the GNPLR levels observed during last 15 years. The assumed crisis under global shocks might pose stability concerns to the banking system.

Likewise, domestic led vulnerabilities also threaten banking sector stability but to a slightly lesser extent. The assumed faster recovery under domestic scenario by the end of projection period could be the reason behind lesser severity of GNPLR levels under Scenario 1 compared with Scenario 2.

(a)     Impact on Solvency 

The impact on solvency is measured via Capital Adequacy Ratio (CAR) of the banking system. As expounded in the scenario design, besides the credit risk, other risks viz., the market risk, realized via movements in interest and exchange rates, as well as the operational risk are likely to have impact on solvency. These risks, therefore, have been factored in while analyzing the impact of each scenario on eligible capital as well as risk weighted assets. Under the business as usual environment, the CAR of the banking system moderately deteriorates by 0.86 percentage points by the end of projection period. This is mainly on the back of existing macroeconomic risks discussed earlier. The CAR, under scenario 1 and 2, falls to 10.45 percent and 8.94 percent, respectively.

More specifically, under Scenario 1 (Domestic Shock), the banking industry breaches domestic regulatory benchmark in fourth year while it falls below the international regulatory benchmark (10.5 percent) in the last year of the projection horizon. (Chart 3.3.7). ^[19] The banking sector’s CAR significantly declines in the event of a global shock. In this case, the industry breaches domestic and international CAR benchmarks, respectively, in the third and fourth years of projections horizon.  It is important to highlight that the domestic CAR requirements are set at levels higher than the global standards.

 

3.3.4 Stress Testing Results – Segment Level

In line with the system-level default analysis, segment level (small, medium, large) infection ratio has also been projected. This aspect of banking industry is included to assess how the cross-sectional heterogeneity affects the resilience of banks against various macroeconomic risks.

For GNPLR, system-level projections of NPLs and gross loans are distributed proportionately based on the contribution of each segment in the loan portfolio of entire banking system as of end 2018. Similarly, capital is also distributed proportionately to compute segment level CAR.

Large Banks

By the end of simulation horizon, large banks witness a rise of 4.63, 11.83 and 14.11 percentage points in GNPLR and a fall of 0.94, 4.45 and 5.45 percentage points in CAR, under scenarios 0, 1 and 2, respectively. Scenario 2 turns out to be the most severe and deteriorates profitability of large banks the most (Chart 3.3.8 (a & b)).

Scenario 2 and CY23 in case of Scenario 1 (Chart 3.3.8 (b)). This implies that the large banks can generally withstand the stress for three years. Reassuringly, the minimum global benchmark, however, would not be violated in any stress scenario over the projection period. Sufficiently higher capital buffers available with larger banks would help them withstand even the severe shocks. More importantly, the systemically important banks remain well capitalized and resilient to support real economic growth even in times of stress, although some deceleration in the extension of loans could be observed.

Medium Banks

By the end of projection period, GNPLR of medium-size banks rises in scenarios 1 and 2 by 6.47, 16.52 and 19.70 percentage points, respectively, while the CAR falls by 0.46, 5.61 and 7.47 percentage points. Again, the adverse impact of shocks emanating under global scenario outweighs the consequences of domestic scenario in terms of severity (& b)).

 

In case of domestic shocks, Scenario 1, this segment of industry breaches local and global CAR standards in CY22 and CY23, respectively. In case of global shocks, Scenario 2, medium sized banks breach local and global CAR standards in CY21 and CY22, respectively.  (Chart 3.3.9(b)). Comparatively higher levels of delinquency ratios and lower level of pre-shock capital buffers possibly make medium banks more vulnerable to shocks.

Small Banks

Small banks are found to be the most resilient against domestic and global shocks. Although, their CAR does fall like large and medium size banks yet, it remains well above both the local and global minimum capital requirements (Chart 3.3.10 (a & b)).

The loan delinquency rate of small banks rises by 4.36, 11.13 and 13.27 percentage points under scenario 0, 1 and 2, by the end of five-year horizon (Chart 3.3.10 (b)), which happens to be the lowest among all three categories. Given the lower exposure, comparatively, in terms of loans, the CAR of small banks rises by 1.16 percentage points in Scenario 0 and by 0.03 percentage points in Scenario 1; however, it falls 0.50 percentage points in Scenario 2. Nonetheless, due to a comfortable pre-shock capital position, small banks demonstrate enough resilience to maintain compliance with domestic and global minimum capital requirements despite credit losses.

Overall, under the baseline scenario, the solvency of banking sector could experience some moderation; however, it remains well above the domestic regulatory capital benchmark. Under hypothetical shock scenarios, nonetheless, the banking sector can withstand some severe and protracted downturn induced by adverse global macroeconomic conditions for three years. In terms of size, all segments of banks including the small, medium and large, can withstand the stress conditions as well. Reassuringly, the large size banks with potential to cause systemic disruptions carry sufficiently higher capital buffers and are thus able to sustain the impact of hypothesized shocks for around four years. The resilience of medium sized banks, however, starts waning after three years, while small size banks never breach the solvency criteria during the projection horizon of five years

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^[1] Usually three types of shocks are considered in stress testing based on the length of the shock events i.e. V-shaped, L-shaped and U-shaped. The shapes are envisaged in terms of recovery. V-shaped assumes quick recovery; L-shape assumes protracted downturn while U-shaped assumes recovery towards the end of projection horizon. Under this terminology, domestic scenario is assumed to be V-shaped, while global as U-shaped. The recovery under the domestic shock takes place earlier while economy takes a little longer to recover under global shock.

^[2] For details, please see ‘Box 4.1 Technical Details’ of Chapter 4: Resilience of the Banking Sector, Financial Stability Review 2016, SBP.

^[3] As per BIS study, one fifth of the authorities use VARs. [Bank for International Settlements. Supervisory and Bank Stress Testing: A Range of Practices. December 2017].

^[4] CPI and PKR-USD exchange rate increased by 6.5 and 26 percent during CY 2018, respectively.

^[5] Policy rate was raised by4.25 percent in CY2018 while development expenditures were cut by 37.2 percent during 2nd half of CY2018.

^[6] IMF World Economic Outlook, April 2019

^[7] IMF World Economic Outlook, April 2019

^[8] River flows constitute, on average, 75 percent of total water supply in the country. SBP Annual Report on State of Pakistan’s Economy, 2016-17.

^[9] Pakistan Meteorological Department (2018). Drought Bulletin of Pakistan, October-December.

^[10] Statistics and Data Warehouse Department, SBP.

^[11] Gross Domestic Savings (as percent of GDP in 2017): Pakistan (6.8 percent), Bangladesh (25.3 percent), India (29.8 percent), Bhutan (25.2 percent), Vietnam (25.5 percent), Malaysia (32.5 percent) and Iran (44.3 percent). Source: World Bank.

^[12] Pakistan Economic Survey 2017-18, Ministry of Finance

^[13] IMF World Economic Outlook, April 2019.

^[14] UK and China are 2nd and 3rd major export destinations for Pakistan. For FY2018, remittances from Middle East economies constitute 57 percent of total remittances in Pakistan.

^[15] World Economic Outlook, April 2019, IMF.

^[16] A rise of USD 12 per barrel is observed in Dubai crude oil price during Jan-Apr 2019.

^[17] https://www.bloomberg.com/graphics/opec-production-targets/

^[18] Eight countries; including China, India, Italy, Greece, Japan, South Korea, Taiwan and Turkey; were granted exemptions expiring May 2, 2019. https://www.state.gov/secretary/remarks

/2018/11/287132.htm

https://www.reuters.com/article/us-usa-iran-sanctions-waivers/

us-grants-temporary-iran-oil-waivers-to-eight-

countries-including-china-pompeo-idUSKCN1NA1OS

^[19] The domestic CAR benchmarks are 11.90 percent (December 2018) and 12.5 percent (December 2019 onwards).

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Section B: Non-Banking Financial Sector

4.1 Performance & Risk Analysis of Development Finance Institutions (DFIs)

The participation in long-term project financing, the core function of DFIs, has remained limited during CY18. Lack of availability of affordable long-term liquidity remains one of the key hurdles for DFIs. Encouragingly, DFIs, have renewed their interest in SME financing, which is beneficial for the economic and financial development of the country. To play their due role, DFIs need to make concerted efforts for resource mobilization and explore the possibilities of arranging funds through other sources, necessary enhancing suit of their asset product and effectively contributing in the economic development of the country.

 

DFIs, in the 60s, have contributed significantly in channelizing funds to the private sector (See Box-4: Brief history of DFIs in Pakistan). However, during the past few decades, the performance of DFIs has remained sub-par and their importance in the financial sector has diminished.

The share of DFIs in total assets of the banking sector is minimal...

The total assets of DFIs amounting to PKR 238 billion represent only 0.92 percent of financial sector assets (1.21 percent of the total banking sector’s assets) (Table 4.1.1). ^[1] The expansion of asset base of DFIs by 4.60 percent during CY18 is less than the growth of 7.31 percent achieved by the banks. This low growth is despite the fact that a new DFI has commenced operations, which contributed to the expansion in assets by 1.61 percent. ^[2] Thus, DFIs, due to their small size, pose limited systemic risk concerns.

DFIs show signs of risk taking…

The asset composition of DFIs, still, remains tilted toward investments. Total assets of the DFIs constitute 51.27 percent investments and 34.53 percent advances indicating risk averse behavior. However, there are indications that the DFIs might be taking more risk. During CY18, the DFIs have increased their lending to SMEs, invested in commercial paper and reduced their stock of government bonds. However, the risk taking ability of DFIs is constrained by the non-availability of long-term funds. The DFIs are mainly dependent on short-term borrowing from the interbank market to finance their asset growth (Chart 4.1.1). Funding constraint is also limiting their ability to extend long-term project financing—their core business.

The maturity profile of advances remains short-term oriented…

Although, the advances have grown at 7.39 percent in CY18 (11.71 percent in CY17), most of the increase has been in advances having maturity of less than 3-years. Further analysis reveals that more than 68.80 percent are maturing in less than 3 years, while only 14.84 percent have maturity over five years. The size of long-term advances further reduces to 10.50 percent if a DFI with a mandate to provide long-term housing finance are excluded. This state of affairs is contrary to the objective of DFIs to provide long-term project financing.

Corporate segment is the biggest borrower though SME financing has increased …

The share of corporate loans in total loans has come down to 78.04 percent in CY18 from 79.22 percent in CY17. It has been made possible due to deceleration in corporate financing and rise in SME financing. Corporate loans have decelerated to 4.39 percent on YoY basis as compared to 15.18 percent growth in CY17. The SME financing has increased by 59.16 percent on YoY basis as compared to 26.82 percent growth in the previous calendar year. The rise in SME financing, apart from other factors, could be the result of indicative targets for banks & DFIs set by SBP.

Flow of advances has increased to Textile sector…

In terms of segment wise advances, the flow of loans is tilted towards textiles followed by cement and electronics and electrical appliances (Chart 4.1.2). As loan portfolio is well diversified among various sectors, it pose no concentration risk.

“Search for yield” motive dominates investment decisions…

A compositional change has occurred in the investment portfolio of DFIs. The amount divested from government securities has been placed in TFCs of private listed companies, likely, in search of higher yield (Chart 4.1.3). Moreover, considering the rising interest rate scenario, the DFIs have off-loaded T-Bills in the first quarter and then made re-investments in PIBs in the third quarter (Table 4.1.2). Moreover, in order to remain liquid, the DFIs have mostly kept their investments in the Held-For-Trading (HFT) (18.09 percent) and Available-For-Sale (AFS) (65.32 percent) categories.

Share of deposits in funding has declined …

Deposits have funded 4.88 percent of total assets of DFIs during CY18 compared 7.51 percent in CY17. They have reduced by 31.97 percent during CY18 compared to an increase of 56.52 percent in CY17. The decline has mainly resulted from shift in deposits to banks in search of higher yield.  

DFIs have limited avenue for mobilizing deposits. Particularly, they raise relatively costly deposits from institutional investors (Chart 4.1.4). ^[3] Moreover, the limited branch network further restricts their ability to attract cost effective deposits. The DFIs need to work on expanding outreach to mobilize additional funding necessary for enhancing the suit of asset products, which will also be helpful in pursuing their renewed commitment to SME financing.

High cost of funding restricts DFIs to play their intermediary role effectively…

Besides issues in mobilizing deposits, the DFIs have limited access to bond market because of underdeveloped capital markets. Resultantly, they resort to inter-bank borrowings to fund their asset base. Inter bank borrowing is actually major funding source as DFIs have funded 46.74 percent of the total asset during CY18. They rely on short term secured borrowings to fund their assets (Chart 4.1.5). This coupled with higher cost of funding make the borrowing expensive thus making it quite challenging for the DFIs to expand their asset base on sustainable basis.

Shareholders’ equity is the prime source of long-term funding…

The shareholders equity is the prime source of financing long-term assets. It is funding 44.42 percent of the total asset base. The shareholders equity increased by 8.66 percent during CY18 primarily due to addition of a new DFI.

Asset quality of DFIs is improving…

The infection ratio of DFIs has declined to 15.83 percent during CY18 (17.15 percent in CY17) (Figure 4.1.6). The decline in infection ratio is attributed to reduction in NPLs stock and increase in advances. Most of the NPLs i.e. 75.17 percent are parked in the loss category. The overall provision coverage ratio is 70.28 percent at the end of CY18. With the expansion in SME financing portfolio, DFIs need to be proactive in managing their credit risk.

Interest income from advances has contributed significantly in net interest income…

Though the profitability of the DFIs has marginally declined during CY18, the net markup/interest income has registered a rise of PKR 574 million. ^{[4] , [5]} However, decline in non-markup/interest income has declined by PKR 735 million (Chart 4.1.7). Further, rise in non-markup/interest expense by PKR 266 million has also reduced the net profits. Resultantly, the DFIs have posted an after-tax profit of PKR 5.0 billion in CY18 as compared to PKR 5.4 billion in CY17. Accordingly, the ROA and ROE have also declined on YoY basis. ^[6]

CAR remains significantly higher than regulatory requirement...

DFIs have high CAR, indicating both underutilized capital and capacity to enhance their financing portfolio. The CAR has marginally declined to 46.95 percent in CY18 from 47.04 in CY17. This downward adjustment has resulted from increase in loans due to renewed interest of DFIs in SME financing and reduction of investments in government securities.

Need remains for enhancing the role of DFIs for contributing in economic activity…

Financial depth is the key to a resilient financial sector, which is also one of the priorities of SBP. Enabling the DFIs to revert to their primary role of providing long-term project financing can help achieve this objective. The main impediment in this regard appears to be the dearth of long-term affordable funding for DFIs. This can be arranged through long-term cheaper credit lines to DFIs from government or multilaterals, as in the past. The World Bank has already provided a credit line to a DFI to refinance the existing mortgages. Besides, DFIs may explore the possibility of securitizing their loan portfolio and issuing bonds/TFCs in the secondary market to tap liquidity. Only then, can the DFIs be able to focus on long-term project financing. 

Box 5: Brief History of DFIs in Pakistan

In developing economies, the DFIs have played a beneficial role by boosting the industrialization process in the early stages of their economic development. ^[7] Besides, DFIs also bring international experience in the domestic market, which adds to the diversity of the existing range of financial services. Over the period, the DFIs have stepped into financing activities like corporate financing, leasing, trade financing, refinancing, SME financing and house financing directly competing with banks. Instead of being a driver for economic development, the performance of DFIs in Pakistan has remained on lower side.

History of DFIs…

DFIs, around the globe, were established in 50s and 60s, as an initiative of the World Bank Group. ^[8] The purpose of the DFIs was to support the developing countries in industrialization process by making available long-term funding through public sector entities. In Pakistan, pre-nationalization, DFIs had played pioneering role in establishing the industrial base. Few of them are PICIC, PIDC and PIFC. However, post nationalization, the DFIs incurred losses due to their financing to loss-making public sector enterprises.

The shift in philosophy of World Bank, globally, from project based lending to program based lending pared down the credit lines, which further worsened the financial health of DFIs.

The reasons for the failure of DFIs have also been identified as strong public sector orientation, political interference, compromised credit standards, non-performing loans and inability to raise funds from the market. ^[9] The DFIs, in the region, which survived were those who had adjusted to market dynamics, diversified their financial activities to strengthen their income stream, implemented corporate governance framework and raised their own long term funding through secondary market. 

Post reforms…

The experiment of nationalization was unsuccessful to obtain the desired results of ensuring flow of financial services to the grass root level (ibid). The government opted for financial reforms, structural adjustment, and privatization. During reforms, few DFIs were closed down and few suffered heavy losses and were on the brink of shut down but rescued by government through considerable financial support. However, post privatization, private sector banks were incorporated with universal banking model that contributed positively in the enhancement of financial services. At the same time, DFIs kept struggling with their financial losses and in the absence of long-term credit lines, could not keep up with the pace of growing banking sector.

Structure of DFIs, at present…

There are 9 DFIs, out of which 7 DFIs have been established in cooperation with bilateral, one DFI is wholly owned by the Government and one DFI is established as a private-public partnership. The purpose for their establishment was to support economic development through financing the industrial sector, extend project financing and facilitate the trade between bilateral. However, their participation in the desired areas is limited due to various reasons including funding constrain

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^[1] Assets of financial sector includes the assets of banking sectors, NBFIs, Insurance and CDNS, while banking sector assets include the assets of Banks, DFIs and MFBs only.

^[2] Pakistan Mortgage Refinance Company Limited (PMRC).

^[3] DFIs can only raise deposits through issuance of Certificates of Investments (COIs) minimum up to maturity of 30 days. Due to limited applicability of BCO, 1962, DFIs are not deposit taking institutions. Hence, they cannot raise the low cost CASA deposits, which raises their cost of funds.

The gross outstanding advances are PKR 90 billion in CY18 as compared to PKR 85 billion in CY17. The increase in interest rates has further increased the interest income on advances.

^[5] The average outstanding amount of investments in government securities during CY18 has been PKR 61 billion as compared to PKR 89 billion in CY17. Therefore, the markup/interest earned on investments has declined by 10.57 percent during the year.

^[6] The sharp decline in ROE during CY18 is due to increase in equity by PKR 8 billion due to entry of a new DFI.

^[7] Yaseen Anwar, 2011, “Role of Financial Institutions and Capital markets in Pakistan”, Speech, PAF Air War College, Karachi, delivered on 21 December 2011.

^[8] MARTÍNEZ, J. (2017). The role of development financial institutions in the new millennium. [Blog] World Bank Group. Available at: http://blogs.worldbank.org/eastasiapacific/the-role-of-development-financial-institutions-in-the-new-millennium [Accessed 5 Mar. 2019].

^[9] Faruqi, S. (2015). The Role of DFIs in Industrial Growth and Transformation: Why the East Asian Countries Succeeded and Pakistan Did Not. The Lahore Journal of Economics, (20), pp.13-33.

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4.2 Performance & Risk Analysis of Non-Bank Financial Institutions

CY18 witnessed an increase in market risk due to volatility in stock market, political uncertainty, rising interest rates and exchange rate depreciation. Though, the slowdown in growth of NBFI sector has been recorded, the availability of various investment options and addition of new firms helped to maintain the asset size of the sector besides adding diversity. Mutual funds, during CY18, have observed net outflow and compositional change. Investors, to safeguard their capital, have switched their investments from equity funds to money market funds. They have also appeared cautious as they took investment decisions by opting non-discretionary portfolio. On the other hand, the companies having financing mandate experienced growth in their assets, except the leasing sector. The assets of investment finance companies have increased on account of addition of two new companies. Further, two new modarabas, after a long time, have been registered and floated in the stock exchange. An increase in assets of NBMFCs has positively contributed to total assets of NBFI sector. In addition, the increasing share of IFCs, REITs, NBMFCs and modarabas may reduce the dependence of NBFI sector on performance of stock market.

Addition of new institutions add to diversity, though the tighter macrofinancial conditions have led to a slowdown in NBFIs asset growth …

The NBFI sector is continuously adding depth to the existing financial sector by catering to the diverse needs of the end users. The recent additions of REITs funds, Pakistan Microfinance investment Company and Private Equity Firms further expand the scope of NBFIs. This diversity helps minimize the adverse impact of any potential risk. 

The total assets of the NBFIs, after witnessing healthy growth in previous years (18.17 percent on an average from FY14 to FY17 (Table 4.2.1), have slowed down during FY18. ^[1] The overall expansion in NBFIs’ assets reflected an increase of only 3.41 percent in FY18 as compared to growth of 31.48 percent in FY17. ^[2]

The slowdown is more visible in NBFIs pegged with equity market…

The overall slowdown in NBFIs assets can, primarily, be attributed to deteriorating economic conditions resulting in volatility in the equity market. The assets of Mutual Funds have decreased by 4.39 percent in FY18 compared to 29.99 percent increase in FY17. Accordingly, their share in total assets of NBFIs has dropped to 58.10 percent in FY18 compared to 62.84 percent in FY17. The assets of AUMs have also decreased by 2.09 percent in FY18 compared to an increase of 24.43 percent in FY17.

On the other hand, the assets of modarabas and NBMFCs have expanded by 20.10 percent and 58 percent, respectively, during FY18. The asset base of IFCs have also increased but mainly due to a conversion of one large leasing company into an investment finance company.  

As is the case in banking, the Shariah compliant structures are gaining popularity in the NBF sector… 

The Shariah compliant structures, which include Shariah compliant mutual funds, Shariah compliant pension funds, Shariah compliant modarabas and the only REIT in operation are attracting investors. The asset size of these structures in total NBFIs assets has increased from 17.86 percent in FY14 to 31.81 percent in FY18 (Chart 4.2.1).

Asset valuation of mutual funds decline in the aftermath of rising macroeconomic vulnerabilities…

The value of mutual funds’ assets has declined by 4.39 percent in FY18 compared to an increase of 29.99 percent in FY17. The assets have lost another 1.91 percent value by end December 2018. The net assets of both the conventional and Islamic equity funds have declined; by 23.49 percent and 19.07 percent, respectively. The bearish stock market sentiments arising out of tighter macrofinancial conditions, political transition and uncertainty about the future economic prospects have been instrumental in the performance of mutual funds and the behavior of their investors.

During CY18, the foreigners, banks and brokers have been net sellers of mutual funds, while insurance, individuals and companies have absorbed all the selling. The continuous risk aversion of mutual fund investors may lead to further asset devaluation.

…and the “flight to safety” motive prevails…

Investors, anticipating further volatility due to rising interest rate risk, have quickly switched from the equity funds to money market funds. ^[3] There has been a decline of 21.97 percent in FY18 in the equity mutual funds. Resultantly, the share of equity mutual funds in net assets of the mutual funds has dropped to 39.38 percent in FY18 from 45.34 percent in FY17 (Chart 4.2.2).

On the other hand, the value of net assets of money market funds has increased by 67.34 percent in FY18 as compared to 40.14 percent in FY17 (47.18 percent in CY18) (Chart 4.2.3). Accordingly, the share of money market funds in the net assets of mutual funds has increased from 13.04 percent in FY17 to 24.30 percent in FY18 (29.86 percent at the end of CY18).

The increasing share of money market funds, in the prevailing macroeconomic environment, indicates low risk appetite of the investors and inclination towards capital preservation.

Pension funds too have been affected by market volatility…

As was the case with mutual funds, risk aversion also prevails in pension funds (Chart 4.2.4). They have not only receded from the equity market, they have also divested away from government exposure. In terms of asset allocation, the pension funds have made placements in equity securities (44.97 percent in CY18 vs. 48.62 percent in CY17), government securities (9.05 percent in CY18 vs. 15.59 percent in CY17) and bank balances (34.61 percent in CY18 vs. 19.43 percent in CY17). As a result, the net asset value of pension funds could only increase by 4.11 percent in FY18 as compared to a growth of 33.41 percent in FY17.

The performance of the pension funds is dependent on the performance of sub-funds. The overall return of the pension fund has remained on the lower side (Table 4.2.2). The returns on the equity sub fund have been negative in FY18. However, during the same period, the money market sub fund and debt sub fund have seen positive returns. Despite the strong management regulatory framework for Voluntary Pension Scheme, high volatility in the stock market may expose the sector to the low returns, which may create socio-economic disturbance.

…and so is the case with high-networth individual Investors

Under the prevailing uncertainty in the market, high-networth individual investors appeared cautious about their investment strategy. They preferred non-discretionary portfolios ^[4] for investment during CY18. In the first half of the year, they relied on fund managers to manage their investment, while in the second half they took decision making into their own hands (Chart 4.2.5). This suggests a general lack of confidence shown by the high-networth individual investors in the ability of the fund-managers to make investment decisions in a volatile market. However, this emerging trend may increase “trading noise” in the market, as large investors are more prone to panic sales that may shorten investment-holding period. They may also be more “risk averse” investing in blue chip stocks, which may limit the flow of funds to the emerging sectors.

The survival of leasing companies is at stake…

The individual business of leasing is on the decline since last few years. As opposed to forty companies in the year 2000, only seven remain at the end of 2018. The entrance of commercial banks in the leasing business in early 2000s and tighter liquidity conditions, made the operating environment difficult.

Moreover, the adverse global financial shock of 2008, which resulted in a steep rise in domestic interest rate, led to an upsurge in borrowing costs and further shortage of liquidity. Resultantly, the companies had to utilize their rental recoveries to pay off their borrowings, restricting new business operations. There was an upsurge in NPLs, which forced the leasing companies to concentrate on managing their infected portfolio rather than expanding their business. As a result, the leasing companies either had to windup or explore other avenues for survival.

In CY18, the largest and profitable leasing company has broaden its scope by converting itself into an Investment Finance Company. ^[5] Resultantly, the assets of the leasing sector have reduced by 76.80 percent from PKR 45 billion in CY17 to PKR 10 billion in CY18. Its share in total NBFI sector assets has also dropped to 0.84 percent at the end of CY18.

Further, the sector is facing poor asset quality. The infection ratio is 73.22 percent and only 76.19 percent of the bad loans have been provided for. Moreover, the sector is no longer profitable; the after tax ROA and ROE stands at negative 0.53 percent and negative 0.13 percent, respectively (Chart 4.2.6).

The NBMFCs are adding depth to the NBFI sector…

The non-bank microfinance companies (NBMFCs) gained momentum during the year and registered an increase of 56.71 percent, which contributed 43.41 percent in overall growth of NBFIs. The rapid growth in NBMFCs is primarily due to availability of market based liquidity from Pakistan Microfinance Investment Company (PMIC). ^[6] The purpose of PMIC is to mobilize funding from both donors and commercial lenders i.e. development agencies, financiers, commercial banks and capital markets and lend it further to NBMFCs. ^[7] Keeping in view the critical role being played by PMIC in the growth of NBMF sector, the health of PMIC becomes paramount. The PMIC may increase the interconnectedness between the banks and the NBF sector, as it has started channelizing liquidity. As the microfinance borrowers are deemed more risky, any asset quality concerns of NBMFCs may have repercussions for the banking sector.

…and so are the modarabas

The growth momentum in the assets of modarabas have continued during FY18. The assets have increased by 20.10 percent as compared to 20.63 percent in FY17. The two new modarabas, after a long time, having the equity of PKR 1.05 billion were floated and listed on the stock exchange. With this addition, the number of modarabas has reached to 27.

Despite this expansion, the concentration in the sector remains high. The top 4 modarabas constitute 73.91 percent of the total assets of the sector. Moreover, there is still room to improve the performance of the modaraba companies. Their potential can be achieved by creating the awareness about the universal applicability of the concept for undertaking multiple activities like financing, manufacturing and trading, some of which may not be handled by Islamic banks.

Assets of REITs have also increased due to revaluation of the underlying property…

There are four REIT management companies, registered with SECP, having accumulated asset value of PKR 5.67 billion at the end of CY18. However, there is only one REIT scheme (the rental REIT) with a fund size of PKR 22 billion and asset size of PKR 46 billion (Table 4.2.3). The expansion in assets of PKR 4 billion during CY18, is backed by unrealized valuation gains from the underlying property.

Moreover, it appears that the investors, in line with the acceptable valuation procedures, have given more weightage to the actual gains from operations rather than unrealized gain from property valuation. The REIT unit has traded at an average discount of 33 percent from its NAV (Chart 4.2.7). ^[9]

Going forward, the business of REIT is expected to improve due to the favorable regulatory changes, introduced by SECP in December 2018, such as allowing REITs to borrow. ^[10] This will provide impetus for the growth and enhance REIT’s attractiveness.

Moreover, the government is also taking measures to promote investment in REIT. The rate of tax on dividend received by corporate unitholders of a REIT has been reduced to 15 percent from 25 percent, vide Finance Act, 2018. The tax rate applicable to dividend received by an individual unit holder from a rental REIT has also been reduced to 7.5 percent. Moreover, in case of developmental REITs the tax on dividend received by a unitholder has also been reduced. The steps taken to promote developmental REITs would also help the government agenda to eliminate the shortage of housing units in the country.

The addition of two new companies change the dynamics of the IFC sector…

The number of investment companies remained same during the year. However, one company ceased to exist due to its merger with a brokerage house and one leasing company has been converted into an investment finance company. Therefore, the assets of IFCs have increased by 181.69 percent during FY18 . Moreover, two companies contain 83 percent share in total assets of IFC as of December 2018. Both the companies are recent addition to the IFC sector.

Further, with the inception of new company in CY17, the advances of IFCs have increased by 11 times from PKR 1 billion in CY16 to PKR 13 billion in CY17. Further, the conversion of a leasing company into investment finance company, the leasing assets of the IFCs have increased by more than 12 times from PKR 1.3 billion in CY17 to PKR 18 billion during CY18. Moreover, the advances and leasing assets of IFC sector have increased by more than 16 times from CY16 to CY18.

As of December 2018, the non-performing assets to total assets have declined to 8.20 percent in CY18 compared to 18.28 percent in CY17 (62.24 percent in CY16). Further, excluding the recently added IFCs, the infection ratio of the remaining companies stands at 34.32 percent out of which 64.78 percent has been provided for.

The new companies also had a beneficial impact on the profitability of the sector. They have pulled out the sector from losses. The after tax losses of PKR 294 million in FY17 have been converted into a profit of PKR 1.6 billion in FY18. Accordingly, the after tax ROA and ROE has increased from negative 1.9 percent and negative 3.8 percent in FY17 to 4.0 percent and 19.8 percent in CY18, respectively. ^[11]

The risks rising from interconnectedness of the bank and non-bank sectors remain low…

There are various channels of interconnectedness between the banking and NBFI sectors. Both the sectors are mainly connected through equity investments, borrowing/lending, investments and deposits (Chart 4.2.9).

Currently, 22 AMCs and IAs are operative out of which 11 are owned by Banks/DFIs. These 11 AMCs have floated 215 funds, which constitute around 85 percent of the total funds. Further, banks owned AMCs have a share of 75.41 percent in the overall assets of the segment (73.07 percent in CY17) (Table 4.2.4). Banks have increased their direct investment in mutual funds. However, the exposure of banks in Mutual funds is not significant.

On the other hand, the exposure of mutual funds on the banking sector has increased through investments in deposits, COD/TDR/COI and money at call/Placement with the banks (Table 4.2.4).

 

However, the slowdown in the NBFI sector has also affected their credit needs. Accordingly, the exposure of banks on NBFI sector in terms of credit lines has reduced during CY18 (Table 4.2.5). Another reason for decline in credit lines from banks is the withdrawal of liquidity requirements for mutual funds. SECP, to support mutual funds, has withdrawn the requirement for asset management companies to arrange credit lines from banks/DFIs equivalent to 10 percent of net assets of each fund. ^[12]

Keeping in view the relative size of deposits, investments and borrowing by NBFIs from banking sector, NBFIs do not pose any systemic risk to banking as well as financial system. However, they carry high reputational risk to overall financial system.

Going forward, the development of financial markets may enhance the complexity of the financial system and so will the interconnectedness among financial institutions. SBP and SECP cognizant of their responsibilities to ensure the stability of the overall financial system and safeguard the interest of customer has taken several measures. One of them is the formation of Council of Regulators, which periodically reviews the performance of the financial system and assesses the risks arising thereof. Moreover, work is underway to establish the National Financial Stability Council (NFSC), which besides the two regulators also includes the concerned ministry.

 

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^[1] Financial Year (FY) for NBFIs ends in June, but for the purpose of complete analysis of CY18 and to give due coverage to the changes experienced in the AMC segment, the Six months period from Jul-Dec, 2018 (or H2CY18) has also been added, wherever possible.

^[2] Though the net assets of NBFIs have expanded by 1.35 percent in H2CY18 against 3.61 percent in H2CY17, the growth is still on the lower side.

^[3] Equity fund has witnessed net outflow of PKR 7 billion in CY18, while net inflow in money market fund stands at PKR 39 billion. The income funds have also observed net outflow of PKR 26 billion.

^[4] Portfolios are investments of eligible investors (person offering a minimum of PKR 3 million investment) managed by Investment Advisors. Under “Discretionary Portfolios”, investment decisions are made and executed by the Investment Advisor on behalf of clients. While under a “Non-Discretionary Portfolio”, investment decisions are made as per the written instructions of the clients.

^[5] The company comprised 80.83 percent of total assets, 92.40 percent of deposits and 64.39 percent of the total equity of the leasing sector.

 

^[6] Pakistan Poverty Alleviation Fund, Karandaaz Pakistan (KRN) and KfW development Bank together created PMIC. 

^[7] As of December 2017, the PMIC had made loans of PKR 11.49 billion to 26 companies. This has increased to 16.67 billion (36 companies) in June 2018.

^[8] Source: Un-audited half yearly report of a REIT

^[9] REIT unit has traded at an average price of PKR 12.51, with a maximum of PKR 13.70 and a minimum of PKR 10.86. While, the average NAV has been around PKR 18.83, with a maximum of PKR 20.32 and minimum of PKR 18.44.

^[10] SECP SRO1473(I)/2018-Notification for REIT’s Amendments dated 5/12/2018 available at: https://www.secp.gov.pk/laws/notifications/

^[11] In FY16, the ROA of IFCs improved noticeably due to recognition of additional tax asset of PKR 480.8 million in respect of unabsorbed tax depreciation and carry forward unused tax losses.

^[12] Direction no. 37 of 2017 dated December 29, 2017 available at: https://www.secp.gov.pk/document/circular-no-37-2017-withdrawal-of-liquidity-requirements-for-mutual-funds/?wpdmdl=30212

 

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4.3     Insurance Sector Performance and Risk Analysis

Despite volatility in the domestic financial markets, which has affected investment income from equity securities, the insurance sector has performed well in CY18. The sector has registered an increase in gross premiums of 9.45 percent mainly due to healthy growth in renewal premiums in the life insurance sector. Further potential for growth exists as the insurance penetration level in the country is less than 1 percent of GDP, which is well below the global average of 6.3 percent recorded in 2016. However, in the current macrofinancial environment, it is expected that the growth trajectory may decelerate in CY19. In addition, the sector is exposed to concentration, market and geo-political risks; while limited domestic avenues for re-insurance can lead to exchange rate risk.

 

Global insurance premiums are expected to continue to grow in 2019 ^[1] …

In the global non-life sector, premium rates have slightly improved in 2018 (3.3 percent) on the back of strong growth in Agriculture Insurance in China and India. Premiums are expected to continue to grow at 3 percent for both life and non-life in 2019-20 driven, in part, by the EMDEs. (Table 4.3.1)

However, underwriting performance needs to be strengthened in order to improve profitability in an environment of increasing claims in the non-life insurance sector. The marine segment is expected to be affected by a potential trade slowdown, which will lead to an overall decline in premiums for non-life. However, pricing has improved in the motor segment. Overall, pricing and underwriting results in non-life are expected to remain stable in 2019.

In 2018, global life insurance premiums have grown by 1.6 percent (which is lower than the average annual growth rates of the last five years) mainly on the back of premium growth slowdown to 1.3 percent in emerging markets (including China). China is estimated to have had a substantial contraction (-1.8 percent) in life premiums due to introduction of tighter regulation of wealth-management-product (WMP) ^[2] types. However, the life premiums for emerging markets are expected to accelerate to 9 percent in the coming two years with China accounting for the WMP shock. While profitability has improved in life insurance sector, the general low interest rate environment remains a concern. Since interest rates are expected to remain stable at current levels (with only marginal increases), life insurers are looking for high equity valuations and diversifying their assets to maintain adequate returns and curb their exposures to market downturn.

Overall, global insurance premiums are expected to grow at around 3 percent in 2019-20 due to above potential global economic growth with emerging markets (especially China) again being the main drivers of premium growth.

In premium-equivalent terms, the global mortality and property protection gap has been estimated at USD 500 billion in 2018, which is about 70 percent of the respective insurance markets. The gap highlights the enormous potential for insurers and if they are able to increase coverage, they can help strengthen the resilience of the global economy.  

The EMDEs are expected to continue to spearhead demand for insurance in the coming years. The low insurance penetration in these economies, coupled with increasing wealth, indicate potential for growth.      

In Pakistan, insurance sector has continued its upward growth trajectory…

Low insurance penetration (0.83 percent of GDP) indicates that there is room for growth in the Pakistani insurance sector (Global insurance penetration = 6.3 percent in 2016 ^[3] ).

The asset base for the insurance sector ^[4] has been estimated to have grown by 10.88 percent to PKR 1,435 billion as of December 31, 2018 mainly due to an increase in the Life Insurance business. Investments and properties have registered an increase of 12.11 percent to PKR 1,128 billion as of December 31, 2018. (Table 4.3.2) 

Equity for the industry has increased by 5.87 percent to PKR 119 billion in CY18 as insurers try to comply with the enhanced regulatory paid-up capital requirements.

Growth in the life sector has been driven by an increase in its core business…

The assets for the Life Insurance sector grew by 11.92 percent to PKR 1,207 billion for CY18 as life insurers increased their Total Investments by 13.52 percent to PKR 997 billion; investments now constitute 82.63 percent of Total Assets.

Life insurers are considered among the large institutional investors for capital and debt markets. Given the volatility in the financial markets, life insurers have decreased their share of investment in equities from 20.32 percent in CY17 to 18.10 percent in CY18 while increasing their share of investment in fixed income and term deposits from 1.93 percent in CY17 to 5.38 percent in CY18. Life insurers continue to have a significant portion (76.14 percent in CY18) of their investments in government securities. 

In addition, the dominant public life insurer has increased its investments in properties by 14.82 percent to PKR 3.7 billion; overall, investment in properties constitutes 0.37 percent of total investments in CY18. 

Growth rate comparison of real GDP and real gross premiums for the life sector shows a positive correlation indicating that an increase in economic activity may lead to an increase in gross premiums for Pakistan. (Chart 4.3.1)

Total gross premium for Life insurance sector has increased to PKR 203 billion in CY18 from PKR 185 billion in CY17. The increase of 19.46 percent in Subsequent Year Premium to PKR 109 billion, coupled with the 12.55 percent YOY increase in Second Year Premium, signifies that the sector has been able to retain its business. Moreover, the First-Year Premium to Gross Premium sustained its growth of 9.40 percent in CY18 indicating that the sector sustained issuance of new insurance policies. The increasing interest rate environment may have led policyholders to look for better rates, which may have led to redemption of policies; this is supported by the spike in Surrender Claims ^[5] in CY18. (Chart 4.3.2)

However, there has been a substantial decline in Single Premium from PKR 16 billion in CY17 to PKR 7 billion in CY18 as a private life insurer registered a significant decrease in this category over the last year. This policy (along with other life insurance policies) is used to claim tax rebate. The reduction in tax rates in 2018 along with the prevailing inflationary pressures (which reduces the net future value of the upfront single premium) may have lowered the demand for this product, as they may no longer form an attractive tax saving option.

Life insurers are required to maintain statutory funds in respect of each class of life insurance business; statutory finds are separate from shareholders’ fund, which contains only those assets and liabilities that are solely attributable to the life insurer. Analysis of statutory funds ^[6] indicates that Family Takaful Fund has shown extraordinary growth for Gross Premiums in CY16 and CY17 of 1190.61 percent and 136.58 percent, respectively. While this illustrates the widespread demand for an Islamic alternative to conventional insurance, the growth rate of Gross Premiums for Takaful Fund is extraordinary because of the small base in 2015. This is demonstrated by the lower (albeit still impressive) growth rate of 34.61 percent to PKR 14 billion in Gross Premiums for Takaful Fund in CY18. Ordinary Life, which includes individual and group insurance, still forms the largest statutory funds; its Gross Premiums have increased from PKR 100 billion in CY17 to PKR 112 billion in CY18. (Chart 4.3.3)    

Due to the initiatives of one of the provincial government to increase health coverage for its population, the gross premium for the public life insurer’s Health Investment Fund has increased by 38.83 percent to PKR 5 billion in CY18. It is expected that there will be further growth in this Fund as the federal government has re-launched a national-wide health insurance program.      

Claims under individual policies increased from PKR 63 billion in CY17 to PKR 72 billion in CY18. This was mainly due to increases of PKR 4 billion and PKR 3 billion to PKR 44 billion and PKR 16 billion in Surrender Claims and Maturity Claims, respectively. Surrender Claims, forming 49.24 percent of Gross Claims for CY18, have registered a 19.05 percent YOY increase, indicating that significant number of policyholders are exiting from their insurance policies before maturity; this development may lead to maturity mismatches for the sector. Several factors have led to an increase in Surrender Claims including the prevailing financial market conditions, which has reduced the value of unit-linked policies (with significant investments in equities); this, coupled with the increasing interest rates, may possibly lead policyholders to surrender their policies in search of higher yields. In addition, in order to meet their sales targets, agents may encourage recycling of policies, which increases Surrender Claims.      

While the Life Insurance sector is relatively stable, some of its indicators have started to deteriorate slightly. Return on Assets has decreased from 0.79 percent in CY17 to 0.69 percent in CY18, as there was only a marginal increase in profitability compared to a significant increase in the asset base for the sector. Profitability was affected due to an increase in management and marketing expenses as some insurers invested in their branch network, salesforce, IT software, etc. for higher future returns. (Table 4.3.3)

In addition, the Claims Ratio has increased from 41.91 percent in CY17 to 43.83 percent in CY18, which is still quite comfortable. In addition, the Return on Investments has increased from 7.10 percent in CY17 to 8.08 in CY18 due, in part, to a tightening of monetary policy in CY18 as the sector maintains a significant portion of investments (76.14 percent) in government securities.

Window Takaful Operators (WTOs) are expected to drive growth in the Family Takaful segment …

The asset base for the Family Takaful segment ^[7] [Full-Fledged and Window Takaful Operators (WTOs)] has expanded to PKR 42,564 million as of December 31, 2018. (Table 4.3.4).

WTOs have accounted for 73.17 percent share in First Year Contribution for Family Takaful, which supports the premise that growth in this sector in the future will be driven by WTOs. In addition, WTOs’ viability can be ascertained by their significant Renewal Contribution (which indicates their ability to retain customers).    

Since these are the initial years of operations, it is expected that the Claims ratio will rise for WTOs (11.37 percent in CY18) as policies become payable in line with that for Full-Fledged Family Takaful companies (45.01 percent in CY18).The growth rate for the WTOs will eventually slowdown as they reach maturity.

The Surplus before Tax for WTOs is PKR 239 million for CY18. While most WTOs have posted losses for CY18, one WTO has posted a Surplus before Tax of PKR 313 million as it has recorded substantial Net Written Contribution in its Individual Family Takaful business for CY18 while Net Claims will only begin to increase as policies become payable.

In addition, Family Takaful companies have posted a Profit before tax of PKR 243 million in CY18.

Non-life sector has witnessed an increase in profitability in CY18…

The asset base for the non-life sector grew from PKR 191 billion in CY17 to PKR 196 billion in CY18 mainly due to an increase of 46.81 percent in investments in term deposits to PKR 12 billion in CY18.

The non-life sector has reduced its overall investments portfolio from PKR 109 billion in CY17 to PKR 106 billion in CY18 as it has divested investments of about PKR 6 billion from subsidiaries and associates (to PKR 27 billion as of CY18). The sector still maintains a significant portion of investments in equity securities (42.34 percent of Total investments and properties portfolio in CY18).  (Chart 4.3.4).  

The sector witnessed a 6.45 percent increase in Gross Premiums to PKR 79 billion in CY18 with Fire & Property Damage and Motor segments being the main contributors of growth.

Net Claims for the Non-life sector grew by 10.06 percent to PKR 23 billion in CY18 mainly due to an increase in Claims against the Motor segment of less than PKR 1 billion. However, the Claims ratio for the Motor segment has declined from 55.06 percent in CY17 to 52.67 percent in CY18, indicating that the absolute increase in motor segment claims is due to an increase in underwriting business for the Motor segment. (Chart 4.3.5)

Overall, the Non-Life sector has witnessed a slight increase in Profitability to PKR 12 billion for the year ended December 31, 2018 (an increase of 0.84 percent over last year) as the underwriting performance for the sector has improved by 13.52 percent to PKR 5 billion in CY18. The improvement in its core business profitability is due to a 42.90 percent reduction in commission expense to PKR 2 billion. However, investment income has slightly decreased by 3.48 percent to PKR 6 billion in CY18 as the non-life sector maintains 42.34 percent share of its investment portfolio in equities, which has been affected by the volatility in the financial markets. (Chart 4.3.6)

Accordingly, the Return on Investment (ROI) has decreased. The Claims ratio for the non-life sector has slightly increased due to a relative increase in Net Claims. Overall, the Non-life sector is stable based on its financial soundness indicators. (Table 4.3.5)

The claims ratio for general takaful segment has declined in CY18…

Window Takaful Operators (WTOs) have led to a 31.96 percent jump in the asset base of the General Takaful segment ^[8] to PKR 11,476 million as of December 31, 2018. (Table 4.3.6)

The Gross Premiums for the segment have increased from PKR 6,430 million in CY17 to PKR 7,872 million in CY18. Net Claims for the sector have increased by PKR 769 million to PKR 3,008 million in CY18. The 34.31 percent YOY increase in Net Claims is still less than the 87.26 percent increase in Net Premiums, which bodes well for the segment.

This has led to a decline in the Claims Ratio for the overall General Takaful segment; it has declined from 86.83 percent in CY17 to 62.28 percent in CY18. The Claims ratio is expected to decline to the levels witnessed by the non-life sector (52.59 percent in CY18) as the segment is expected to continue its impressive growth trajectory for the next year which will help spread risks over more customers (thus, reducing the claims ratio). 

Profitability for the General Takaful segment has improved from PKR 224 million in CY17 to PKR 422 million in CY18 mainly due to a 108.60 percent increase in Net Contribution for WTOs to PKR 4,277 million.

In addition, the WTOs have been able to reduce their Claims ratio from 81.21 percent in CY17 to 55.95 percent in CY18, as WTOs have been able to exploit economies of scope of their conventional companies, which has helped them increase their gross premiums. Consequently, the share of WTOs in the General takaful segment profitability has increased from 40.01 percent in CY17 to 69.72 percent in CY18.   

The reinsurance company has posted healthy underwriting results in CY18…

Section 41 of the Insurance Ordinance, 2000 requires insurers to maintain reinsurance arrangements for insurance risk management as mentioned in the Ordinance.

The Pakistani insurance industry has only one public reinsurer, which caters to the non-life sector. To meet their reinsurance needs, the Pakistani insurance industry has reinsurance arrangement with leading international reinsurers such as Hanover Re, Swiss Re, Munich Re, etc.

The public reinsurer has increased its asset base from PKR 24,342 million in CY17 to PKR 24,831 million in CY18. Gross Premium has increased from PKR 8,036 million in CY17 to PKR 10,734 million in CY18 as all segments (including Treaty business and Facultative business) were profitable. Gross Premium for treaty business, which forms 41.57 percent of the total portfolio, increased by 32.44 percent to PKR 4,462 million in CY18.  (Table 4.3.7)

The Claims Ratio for the reinsurer has decreased from 74.71 percent in CY17 to 54.76 percent in CY18 due to a 9.15 percent increase in Net Premiums and a 20 percent decrease in Net Claims over CY18, which is a PKR 748 million decline in overall Net Claims. Net Claims for the Engineering segment was the main contributor to the decline as it fell from PKR 500 million in CY17 to PKR 60 million in CY18. 

The underwriting results for the reinsurer have registered a profit of PKR 581 million in CY18 after registering a loss of PKR 677 million in CY17. Despite an improved underwriting performance, the reinsurer’s overall profitability registered a decrease to PKR 1,740 million in CY18 compared to PKR 2,876 million in CY17. This was due to a one-off Gain on sale of NIT units worth PKR 2,791 million in CY17, which inflated the profits for that year. (Chart 4.3.7)

Overall, the non-life sector has ceded reinsurance worth PKR 35,540 million in CY18 (PKR 32,014 million in CY17). The ratio of Reinsurance Expense to Net Premium for the non-life sector has remained stable around 74.73 percent in CY18 (74.7 percent in CY17). 

Life insurers have ceded reinsurance worth PKR 2,570 million in CY18, which is up from PKR 2,167 million in CY17. The Premium Retention ratio of 98.73 percent indicates that the life insurance sector cedes little reinsurance premium to reinsurers. The associated reinsurance risk may be mitigated as most life insurers maintain adequate capital and Statutory Fund balances to absorb losses from a rise in claims or contingencies. In addition, many private life insurers are part of large corporate groups, which can help mitigate the risks from unexpected losses. However, some life insurers still need to improve their underwriting performance.  

The public sector insurer still dominates the life insurance sector…

There are significant public insurers in the life, non-life and reinsurance sectors of the economy. One public life insurer still has more than 60 percent share in the asset base of the total insurance sector while the public non-life insurer (along with a few private non-life insurers) are significant players in the non-life sector. In order to mitigate systemic risk, these firms may need to undergo enhanced supervision and regulation.   

Pakistan has witnessed rising volatility in the domestic financial markets in CY18; this has led to increased market risks for insurers. This has resulted in insurers increasing their investments in relatively risk-free categories i.e. government and fixed income securities. However, the increasing interest rate environment leads to a lower revaluation of fixed income securities (interest rate risk). Despite this risk, life insurers tend to invest in long-term government bonds to match the duration of their policyholder’s liabilities (to mitigate maturity mismatches).

The economic and geopolitical risk is high which leads to adverse business conditions, which might impede the growth for the sector. In addition, the economy is expected to grow at a slower pace in CY19; this, coupled with the India–Pakistan border skirmishes in early 2019 indicates that the economic and political risk will remain high in CY19. The insurance sector is expected to adopt a cautious approach, cut costs, and improve underwriting performance to mitigate such risks. 

In addition, while all life insurers are solvent, at least five ^[9] non-life insurers do not meet the solvency requirements. One of these insurers has recently undergone a change in management and may be able to turn around its position, while another insurer is in the process of merging its operations with another firm. A few other insolvent insurers need to prepare and implement viable recovery plans (including improving their profitability, capital adequacy and solvency margins) or consider consolidation with other insurers, as they may also not be able to comply with enhanced regulatory capital requirements.  

The insurance regulator has strengthened the industry’s regulatory framework…

The Securities and Exchange Commission of Pakistan (SECP), the insurance regulator, took the following major initiatives ^[10] in CY18 to strengthen the regulatory regime after the issuance of the Insurance Rules in CY17:

·         Notification of the Credit and Suretyship (Conduct of Business) Rules, 2018 w.r.t. insurance guarantees

·         Amendments to the Insurance Rules, 2017

·        Issuance of Circular on dollar-denominated insurance policies

·         Initiatives taken under the National Financial Inclusion Strategy (NFIS) e.g. reducing the verification services’ cost for micro insurance policies

All of these efforts are expected to provide insurers a conducive environment for growth in the future. 

Gross Premiums are expected to grow at a slightly lower rate in CY19…

Going forward, the main drivers of growth include the increasing purchasing power of the middle class, the use of bancassurance, Window Takaful Operations, government’s health insurance expansion initiatives, launch of micro-insurance products, etc. Accordingly, the insurance industry’s asset base is expected to expand further in CY19. 

As Insurance Premiums and economic growth have a positive correlation ^[11] , it is expected that Gross Premium will increase at a decelerating pace in CY19.

The insurance regulator’s capital requirements may lead to consolidation in the insurance industry with some insurers expected to merge or acquire smaller insurers. This is expected to contribute to the stability of the industry.

The Health segment premiums are expected to receive a boost as the government plans to expand its National Health Insurance Program. The Program is also expected to increase the share of dominant public life insurer in the Health segment as the government will provide national-level health coverage through the public life insurer; the government has previously used the public life insurer to launch a similar program in KPK. In addition, it is expected that overall claims for the public life insurer (and, in turn, for the life insurance sector) will rise as new business is underwritten for the Health Insurance Fund, which has a claims ratio of 83.78 percent in CY18.

 

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^[1] Swiss Re – Global economic and insurance outlook 2020

^[2] A wealth management product is an uninsured financial product (generally offering high rates of return) sold in China by banks and other financial institutions. They are considered to have financial stability implications.

^[3] Swiss Re Institute

^[4] The analysis is based on the data of 5 life insurers and 28 non-life insurers covering approximately 97 percent and 78 percent of the life and non-life insurance sectors’ assets, respectively.  The analysis covers data up to period ending December 31 2018. Data has been estimated, where necessary. The financial close for insurers is December of the corresponding year. All growth ratios are on year-on-year basis.

^[5] Please see next page for discussion on Surrender Claims

^[6] There is overlap between the statutory funds, as certain funds in Pakistan have features of two or more different funds.

^[7] This is the first year where separate financials became available for Window Takaful Operators (WTOs) operating in the Family Takaful segment. This section covers both WTOs and full-fledged Family Takaful companies. In the rest of the chapter, WTOs operating in the Family Takaful segment are included in the consolidated financials of the conventional insurers.

^[8] This section covers both WTOs and full-fledged General Takaful companies. In the rest of the chapter, WTOs operating in the General Takaful segment are included in the consolidated financials of the conventional insurers.

^[9] There may be additional non-life insurers, which are insolvent. However, nothing concrete can be said about their health, as these insurers have not shared their financial information.

^[10] SECP Annual Report 2018

^[11] Rudolf (2000), “The S-Curve Relation between per-capita income and Insurance”

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4.4 Performance and Risk Analysis of Exchange Companies

The performance of the Exchange Companies (ECs)—on the back of healthy expansion in asset and improved income—has remained encouraging during FY18. The growing demand for US dollars and rising kerb premium has resulted in an uptrend in foreign currencies exports. The role of ECs remains limited in facilitating inward remittances. SBP is strengthening the AML/CFT regime of Exchange Companies to mitigate the associated risks. Besides, major challenges faced by ECs relate to operational constraints emanating from uninsured cash and limited adoption of technology-based business applications. However, owing to their small size and limited interconnectedness with the banking sector, the ECs do not represent a possible source of systemic risk, though reputational risk remains.

 

There is synchronized upturn in assets and income during FY18…

The asset base of the Exchange Companies (ECs) has risen by 17.56 percent during FY18—up from 10.70 percent in FY17, primarily on account of rising fixed assets (branch expansion) and appreciation of USD, supported by 7.73 percent increase in paid-up capital. ^[1] In addition, the Return on Equity (RoE) has almost doubled to 8.65 percent during FY18 from 4.48 percent a year earlier. ^[2] Resultantly, the expenses to income ratio has declined, indicating improved operational viability (Chart 4.4.1).

Income of ECs rises as dealings in FCY surges…

Selling foreign currencies (FCY)—that are in high demand—in the domestic market is a major source of income for ECs. Since US dollar commands highest demand in the domestic market, ECs profit through its sale-purchase transactions. They also benefit from export of FCYs that have low domestic demand. ^[3]

In FY18, ECs have exported USD 2,479.0 million worth of foreign currencies—up from USD 1,897.0 million in FY17. They have exported another USD 1,316 million worth of FCYs during H2CY18. These exports increase the supply of US dollar with the ECs, allowing them to do more sale-purchase transactions.

The rising external account vulnerabilities—in the backdrop of falling SBP forex reserves—have led to an increased volatility in the open market exchange rate and higher kerb premium (the difference between open market and inter-bank exchange rates). Rising kerb premium seems to be one of the reasons behind increased purchases from individuals of foreign currencies other than US dollars ^[4] , which, in turn, have pushed up their exports. (Chart 4.4.2)

The inward remittances rise while the outward remittances contract…

In CY18, inward remittances received through ECs have accelerated by 8.35 percent (USD 1,328 million)—up from 1.50 percent (USD 1,225 million) in the previous year. Moreover, in CY18, the inward remittances through ECs has accounted for 6.98 percent (on average) of the total inward remittances—slightly up from 6.73 percent in CY17. The ECs have channeled 7 percent of the total inward remittances in the last 4 years (Chart 4.4.3). Increased remittances inflow is due to additional bilateral arrangements of ECs with overseas tie-ups. Positively, it might have helped ease some dollar liquidity pressures witnessed during the reviewed year. 

On the contrary, outward remittances show contraction of 7.74 percent in CY18 against growth of 2.53 percent in CY17. It seems that PKR depreciation has dampened the outflow of foreign currencies and served to provide some relief to the forex market. Moreover, the trends of inward and outward remittances have been diverging (Chart 4.4.4).

SBP’s regulatory regime relating to ECs addresses the risks of money laundering and financing of terrorism …

SBP, in order to mitigate the ML/FT risk, has put in place a comprehensive regulatory and supervisory framework, which is collected in the form of an ECs Manual. ^[5]

SBP has introduced various new measures during CY18. To enhance the documentation of transactions, exchange companies have been directed to retain copies of identification documents for all foreign currency transactions equivalent to USD 500/- or above. ^[6] In order to further strengthen the regulatory AML/CFT requirements, exchange companies have been required to record the inland movement of foreign currencies within their authorized branch network. ^[7]

Also, instructions have been issued under UNSC resolutions and Anti-Terrorism Act, 1997 to ensure proper screening of proscribed entities and individuals. ^[8] Moreover, regular on-site inspections are also conducted by SBP to warrant its enforcement.

Uninsured cash and limited adoption of tech-based business applications may raise operational risk…

Cash constitutes a sizeable portion of exchange companies’ assets. Being a risky asset, prone to theft or destruction, uninsured cash poses a key operational risk. Owing to their small size and inherently high risk of dealing in cash, the cost of insurance becomes unfeasible leaving them vulnerable to asset losses.

With a view to improving the operational risk management, the mechanism for monitoring through Close Circuit Television (CCTV) cameras installed at company outlets has been standardized by SBP. Resultantly, the improved surveillance will not only minimize the operational risk but will also strengthen supervisory oversight of SBP. ^[9]

Furthermore, the level of adoption and sophistication of technology-based solutions remains low, due to inadequate investment in related technology infrastructure and human resources.

…however, systemic risk remains contained…

In aggregate, the exchange companies sector is characterized by small balance sheet size and limited inter-connectedness with the banking sector. The overall share of ECs in the total assets of the financial sector stands at 0.06 percent as of end June-2018. Similarly, only two ECs are operated by banks as their subsidiaries, which manifests limited exposure of the banking sector, though reputational risk remains. All-in-all, the risk from ECs may not be systemic in nature.

Minimizing operational risk and improving governance are key priority areas for ECs…

Going forward, the focus of the exchange companies must be on limiting operational risk. Improvement in operations will not only expand their customer base but will also aid in achieving a stabilized exchange rate, through efficient management of supply of foreign exchange. Moreover, employment of technology-based governance applications will also support them in mitigating the risk of non-compliance with relevant regulations and laws.

 

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^[1] The ECs assets comprise of Cash, fixed assets and intangible assets. The balance sheet data is available up to June 2018 (FY18).

^[2] Total income has risen by 38.55 percent in FY18 against 17.89 percent in FY17.

^[3] Exchange Companies (only A category) are permitted to export foreign currencies—except for the US dollar—that are domestically not in demand and bring in equivalent US dollar in form of cash and through their FCAs maintained with banks in Pakistan. However, ECs are directed to sale at least 10 percent of the proceeds from export of FCYs in interbank market on an ongoing basis.

^[4] Rising kerb premium incentivizes non-resident Pakistanis to bring home foreign currencies and convert them into PKR at a better exchange rate.

^[5] ECs Manual 2018 lays out a robust set of guidelines covering areas such as documentation of transactions, Know Your Customer/ Customer Due Diligence (KYC/CDD) measures, identification of beneficial ownership, reporting of suspicious transactions/currency transaction reports, record-keeping and capacity building of human resource etc.

^[6] EPD Circular Letter No. 08 of 2018;

http://www.sbp.org.pk/epd/2018/FECL8.htm

^[7] FE Circular No. 05 of 2018;

http://www.sbp.org.pk/epd/2018/FEC5.htm

^[8] FE Circular No. 09 of 2018;

http://www.sbp.org.pk/epd/2018/FEC9.htm

^[9] FE Circular No. 15 of 2018;

http://www.sbp.org.pk/epd/2018/FEC15.htm

 

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Section C: Non-Financial Sector

5 Performance and Risk Analysis of the Corporate Sector

The tighter macro-financial conditions and uncertainty about future economic prospects has dampened the performance of the corporate sector. The asset base shows growth, while sales growth decelerates and the profitability, liquidity and operational efficiency indicators trend downwards. Disaggregated analysis highlights that operational efficiency indicators of cement and power sectors face major contraction. The investors’ perception about the corporate sector has also weakened as illustrated by the decline in equity market and leading market indicators. However, the key financial and performance indicators remain in a comfortable range. The concerted efforts of the policy makers, however, may further improve the environment related to ease of doing business.

 

The interconnectedness remains strong between the corporates and the banking sector…

In Pakistan, financial institutions (banks and DFIs) are the key source of financing for the corporate sector, as the capital market depth remains limited. Lending to corporations constitutes 71 percent of banks and DFIs’ domestic advances portfolio as of end CY18 (Chart 5.1, Chapter 3.1 and Chapter 4.1). As such, strong interconnectedness exists between the two sectors, thus, a shock in any one of them can adversely affect the operating performance and solvency of the other.

Corporate sector’s performance dipped in CY18 in the wake of challenging macroeconomic environment…

The increase in the interest rate from 5.75 percent in CY17 to 10 percent by end CY18 has jacked up the financial cost for the corporates across the board contributing to the fall in profitability (Chapter 1). Exchange rate depreciation, on the other hand, has had mixed impact on the performance of the firms. It has caused a hike in the cost of production of corporations that rely on imported components, while export-oriented firms may have benefited in terms of price competiveness in the international markets.

Overall, the assessment indicates signs of slackening in the operating performance and financial strength of corporates (Table 5.1). ^[1] The pro-forma financial statements (covering 84.17 percent of total assets of listed companies) indicate that the gearing and leverage of the corporates have inched up. ^[2] Whereas, the liquidity indicators, along with debt repayment capacity and profitability, have depicted a slight decline.

Corporate sector’s reliance on borrowings for growth and liquidity rises…

The asset base of the corporate sector has observed 16.22 percent growth in CY18 at the expense of increased leverage. The growth has largely been contributed by operating fixed assets, which have been growing in line with the capacity enhancement in a number of sectors. Long-term lending by financial institutions, comprising 45.21 percent of total lending to the corporate sector, experienced a growth of 18.16 percent in CY18. Consequently, the corporate entities have witnessed increase in their gearing and leverage. A 23.06 percent growth in non-current liabilities has been recorded in CY18, which is greater than preceding three years’ average growth of 8.86 percent 

Moreover, the key liquidity indicator i.e. current ratio has contracted from 1.35 in CY17 to 1.23 in CY18. The current liabilities, mainly because of short-term borrowings, have witnessed faster growth compared to current assets (Chart 5.2). The accelerated 38.76 percent YoY growth (19.77 percent in CY17) in financial institutions’ lending for working capital further substantiates this phenomenon.

…and the sales growth decelerates…

During the year under review, the sales growth decelerates to 13.39 percent (18.29 percent in CY17), as rising inflation and a challenging economic outlook affected both the purchasing power as well as the spending activities in the economy. Simultaneously, the cost of sales has also risen. Cumulatively, they have had a major impact on the profitability of the corporates as reflected by a subdued growth in operating profit that stands at 2.91 percent in CY18, against 18.75 percent in CY17.

Despite some drop, the debt repayment capacity remains comfortable…

The debt repayment capacity of the corporate sector has somewhat softened in CY18 as the interest rate has spiked and sector’s leverage has further risen. Besides the inch up in the debt to equity ratio, the interest coverage ratio has deteriorated from 7.92 in CY17 to 6.80 in CY18. However, these indicators still seem better than what they used to be a few years back.

Financial leverage has supported the profitability, however, it entails risks…

Among the profitability indicators, the base line indicator ROE has decreased from 15.99 percent in CY17 to 15.27 percent in CY18 (Chart 5.3). The Extended DuPont analysis reveals that ROE has declined in CY18 due to increase in interest burden. Besides, decline in operating profit margin and asset usage efficiency further contributes towards the contraction in ROE (Table 5.2).

On the contrary, drop in the corporate tax rate from 31 percent (CY17) to 30 percent in CY18 has reduced the tax burden of corporates. ^[3] Similarly, increase in the financial leverage supported the ROE as it has absorbed a part of the dampening impact coming from weakening operating performance and rising interest rate burden. ^[4] The use of borrowing to support the declining liquidity and profitability is not sustainable. This is because after surpassing a certain threshold, the interest burden will supersede the benefits from the financial leverage. Thus, the increased financial leverage will entail risks in terms of solvency, gearing and debt repayment capacity.

KSE-100 index reflects the weakened market perception regarding the corporate sector…

The slacking operating performance of the corporates is also reflected in the downward movement as well as high volatility of the KSE-100 Index in CY18 (Chart 5.4). During CY18, the KSE-100 index after touching a reviewed year’s peak of 46,580 points in April 2018 has declined to 37,067 points that translates to a dip of 20.4 percent. During the same period, the P/E ratio has dipped to 8.9 from 10.8, illustrating a decline of 17.59 percent. The reduced valuation reflects a general decline in investors’ confidence about the operating performance and future prospects of the corporates (See Chapter 2).

The sector-wise analysis reveals mixed performance…

Macroeconomic stress has directly affected the sales performance of corporate entities in various sectors. The cement and power sectors experienced negative sales growth. Whereas, the oil & gas sector, along with textiles and automobiles have enjoyed the positive sales growth (Chart 5.5). Cumulatively, these three sector comprise of 66.9 percent of the aggregate corporate sector sales in CY18. Comparatively, last year all sectors experienced a positive sales growth. Power, food and textile sectors turned out to be the most leveraged sectors in comparison to other sectors and they lag in liquidity and operating performance indicators.

Rising input costs and lower demand pulls down the cement sector…

Cement sector’s financial and operational performance has declined in CY18, mainly due to, rising input costs (rise in coal and fuel prices) and reduction in demand (as fiscal constraints have led to a reduction in Public Sector Development Program (PSDP)). As a result, the revenues of the cement sector have declined by 10.26 percent. The positive aspect for the sector is the growth in exports, which have increased by 36 percent. ^[5] The exchange rate adjustment has supported the competitiveness of the sector; however, exports at present are only a nominal part of the aggregate cement sales. The outlook for the cement sector is positive in the context of material developments regarding Mohmand and Diamer-Bhasha dams and an expected pick-up in construction and housing activities.

Power sector is burdened with the circular debt…

Power sector’s performance has slowed down during this year. The sales have decreased by 11.49 percent on year-on-year basis, mainly due to lower power generation during the year. ^[6] Primary risk faced by the power sector is the accumulation of circular debt mainly due to incomplete recovery of electricity bills and increasing transmission and distribution losses. However, the government is taking measures to curb the levels of circular debt by banning furnace oil imports, increasing the energy prices and moving towards coal and RLNG power generation.

Oil & Gas, the leading sector, performs better in CY18…

Oil & Gas is the leading sector in terms of both market capitalization as well as the quantum of borrowings from the banking sector. In CY18, its profitability has improved primarily due to the rise in sales by 21.39 percent. However, it has faced higher financial charges due to magnitude of its borrowings coupled with monetary policy tightening during the year under review. Moreover, most of the refineries are in an expansion phase and require funding to keep the work flowing. During the year under review, this sub-sector effectively weathered some pressures i.e. devaluation of the currency, exchange rate losses and slowdown in economic activity. Going forward, the performance of this sub-sector will largely depend on the demand and prices of automobile fuel. Moreover, the general abolishment of the Super Tax will have positive impact on the sector. ^[7]

Textile sector stands at the bottom in terms of profitability and liquidity…

The textile sector has recorded the lowest profitability amongst all sectors, though it has improved in CY18 (Chart 5.6). Although, devaluation of the currency has made textile exports competitive and the government’s incentive to provide uniform gas prices has helped profitability, the dependency on imported cotton, imported machinery and aggressive competition in value-added segment from Bangladesh and Vietnam confines the textile sector’s revenues and margins.

The outlook may improve if the government targets higher cotton production as the currency devaluation has made imported cotton less competitive in the local market. Nevertheless, some challenges need to be addressed that include improvement in product quality and research and development.

Automobiles sector’s high performance is expected to attract capacity enhancement in coming years…

Automobile sector has the highest operational efficiency in the corporate sector. It has, however, faced a contraction in the gross profit margin in CY18, as the bar on non-filers against purchase of new car affected the demand and the devaluation of the currency put pressure on production costs and profit margins. Resultantly, local assemblers increased their prices to sustain profitability. The outlook is positive in terms of enhanced production capacity as Kia, Hyundai and Renault are expected to enter the market in the coming years. Further, the enhancement of federal excise duty (FED) on imported vehicles could increase the demand for locally assembled vehicles. However, because of increase in FED on the imported parts, automobile assemblers, who mostly rely on imported components, might be negatively affected. ^[8]

Altman Z-Score highlights the growing credit risk in some of the key sectors…

The slowdown in economic activity and the challenging macroeconomic environment have dented the business operations and performance of corporate entities. The increased volatility and a general decline in stock prices negatively affected the fair market value of firms and weakened their financial position in terms of the solvency cushion. These developments also reflect a general decline in these firms’ weighted average Altman Z-score that is used to assess the firm’s financial health and likelihood of failure.

In CY18, the sub-sectors including textiles, cement and power faced the greatest decrease in the market value. Thus, they are ranked lowest on the Altman’s z-score model. The credit worthiness of the other sub-sectors also decreased as their Z-score contracted; however, they are still within the safe range. (For details please refer to Box 5 which discusses the overview of Altman Z-Score model and detailed assessment of Pakistan’s corporate sector on this model.)

Probability of default (PD) has observed some increase for most of the sectors…

The weighted average PD of corporate sector, from CY16 to CY18, depicts an increasing trend, for both 1 year and 5 year horizon (Chart 5.7). ^[9] In CY18, weighted average PD of the corporate sector stands at 0.03 percent and 0.21 percent for 1 year and 5 year respectively. The disaggregated assessment indicates that textile sector has the highest PD, in CY18, for both 1 year and 5 year, 0.98 percent and 4.31 percent, respectively. Given the adverse economic and political factors, the trend of 1 year PD has increased for all the sectors, except chemicals and oil & gas sectors (Chart 5.8). Similar trend also appears in the 5 year PD.

The trend of PD supports the findings of the Altman’s Z-score as both models estimate increasing PD due to the weakening and increased volatility in firms’ market value. The softening of financial and operating profit indicators have somewhat contracted the solvency cushion and contributed indirectly to the volatility of the market value of the firms. Therefore, the lower market valuation, besides sentiments of the investors, is also being driven by weaker fundamentals.

Credit risk ratings culture, though not wide spread, shows improvement…

Besides financial health, the ability of the entities to honor their financial obligations can be gauged by their credit risk ratings. However, the rating culture in Pakistan is not wide spread, as a major portion of entities remain unrated. Out of the selected sample of listed entities, only 31.68 percent of them were rated in CY18. However, the rating culture showed improvement as in CY17 only 18.15 percent of the sampled entities were rated (See Chapter 3.1).

It is generally the case that well performing corporate entities get themselves rated and mediocre performing entities avoid being rated. The inherent nature of bank-dominated finance and costs associated with the ratings discourages the companies to get themselves rated. ^[10] However, going forward, considering the dynamics of international and domestic regulatory environment, ratings could gain more traction.

Out of rated entities, major chunk of the companies lie in high credit quality cluster in terms of long-term ratings, which includes ratings of A+,A and A- (Table 5.3). Whereas, in terms of short-term ratings, majority of the companies are rated as A1 that is strong capacity for timely repayment. ^[11]

Ease of Doing Business ranking has improved…

An enabling business environment stimulates the growth of entrepreneurship in a country. The ease of doing business index, issued by World Bank, measures the extent to which the policy and regulatory frameworks support the ease of doing business. According to the World Bank’s latest report, Pakistan has improved its ranking from 147 to 136 out of 190 countries in 2019. ^[12] . Noticeably, the improvement in the ranking has come on the back of score improvement in different indicators of the doing business index. The major three indicators, which have witnessed significant improvement in scores included, resolving insolvency (from 45.8 to 59.9), starting a business (from 76.6 to 81.9), and registering a property (from 41.3 to 45.6) and (Chart 5.9). Some other areas where the score has improved are dealing with construction permits, getting electricity and paying taxes. The resolving insolvency score has improved due to the introduction of reorganization procedures and improvement in continuation of the debtor’s business during insolvency proceedings. ^[13] Likewise, enhancement of online one-stop registration system by Government of Pakistan has aided the starting a business segment. Fundamentally, several forms for incorporation of a business have been replaced with a single application and information sharing between registry and tax authorities have been introduced.

Although the ease of doing business score, which forms the basis of the ranking, has improved to 55.31, it is still below the South Asian regional average score of 56.71. In order to improve the score and, therefore, the rankings, substantial reforms, under various indicators, at both the provincial and federal levels need to be accelerated. For instance, development of a new container terminal and enhancing the customs platform i.e. National Single Window for electronic document submission will help in improving our score in the trading across borders indicator. ^[14]

Outlook for the corporate sector is positive…

The performance of the corporate sector in the coming year is dependent upon various factors.

Improvement in the macroeconomic conditions, especially the current and fiscal account deficits are necessary for economic stability. The government is enthusiastically endeavoring to overcome these economic challenges. It is expected that further positive developments and the conclusion of the agreement on IMF program could subside these challenges and pave the way for strong growth in the future.

In the short run, the IMF Program might accelerate inflation and subside the growth in the economy; however, in the long-run, it may stabilize the growth in the economy and restore investor’s confidence in the equity and forex markets.

Furthermore, the abolishment of the Super Tax on the non-banking companies and reduction of corporate tax rate in the coming years can augment the performance of the corporate sector. However, imposition of any additional taxes could impede the performance of the corporate sector.

Additionally, under the umbrella of CPEC, some initiatives have been taken to develop special economic zones to promote the collaboration of Chinese and local industries. The development of the Gwadar port with the aim of transforming it into a trade hub could also open up business opportunities. These developments can potentially contribute positively to the economy and the corporate sector of Pakistan.

 

Box 6: Altman Z-score – Measure of distress

The Altman Z-score is a statistically driven empirical model that is, generally used to assess the health of firms. Particularly, it measures the liquidity conditions as well as predicts the probability of insolvency and financial distress.

The Altman Z-score is derived from several key ratios that measure different key aspects of a corporate entity’s financial health and performance. The score consists of five variables:

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = EBIT / Total Assets
X4 = Market Value of Equity / Total Liabilities
X5 = Net Sales / Total Assets

The Z-score is calculated by the following formula ^{[15] , [16]} :

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 0.999*X5

To apply the model on the corporate sector of Pakistan, 303 listed companies are selected as a sample. These corporations are categorized into eight sectors, namely, textile, oil & gas, chemicals, power, cement, automobiles, foods, and pharmaceuticals. Based on the individual scores of these selected firms, the aggregate weighted-average scores of all sectors have been calculated for the last three years (Table 1.1).

In line with slowdown in economic activity and contracting market value of corporate entities that prevailed during the year under review, the weighted average Z-score of all the sectors declined in CY18 as compared with the previous year’s assessment. Noteworthy sectors highlighted by the Z-score are textile, power and cement. The scores of these sectors fall in the lower ranges, which as per the original Z-score model are considered distress zone. This urges rigorous measures for improving the financial position of firms. All the remaining sectors are placed in the safe zone except for the oil & gas sector, who fell in the grey zone and skewed towards the safe zone (Chart 1.1).

Taking into account the Z-score of the preceding years, the textile sector continually stays in the distress zone and oil & gas sector stays in the grey zone. Whereas, the power sector that is on the borderline of distress zone for the last two years, demoted into the distress zone in CY18. Following similar footsteps, the cement sector started to decline from the safe zone in CY16 into the distress zone in CY18 (Chart 1.2).

According to the applied model, textile sector constantly falls under distress zone due to the poor working capital management as compared with the other sectors that has lead them to earn lowest ROE. Moreover, the market value of equity as the ratio of book value of debt also remains quite low constantly.

Cement sector faces the most drastic decrease (70.5percent from CY16 to CY18) in the Altman Z-score. Primarily, the higher rate of growth of debt levels as compared with the growth of asset base lead to decline in the score. Simultaneously, the weakening of working capital affected the liquidity position of the sector. Over the years, the market value of equity of the cement sector also deteriorated as a reflection of poor performance. Thus, in CY18, the Z-score stands at 1.32.

The Altman Z-score of the remaining sectors also decreased during the CY18, given the slowdown of economic activity (Chart 1.3). Besides cement sector, the pharmaceutical and automobile sector faced severe decrease in the Z-score. Nevertheless, their score remains quite above the safe zone.

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^[1] The corporate sector performance has been assessed using financial statements of 303 companies listed on Pakistan Stock Exchange (PSX). As such, the analysis entails generalization for the entire corporate sector.

^[2] For 2018, the detailed financial position and performance have been interpolated based on the key summary statistics (i.e. Total Assets, Shareholder’s Equity, Sales and Profit) which had been reported by these companies at the time of this assessment exercise.

^[3] http://www.finance.gov.pk/

budget/budget_speech_english_2018_19.pdf

^[4] Keeping the Financial Leverage constant for the CY18 at 2.14, the ROE will fall to 14.4 percent. Thus, the increase in financial leverage has provided cushion to the declining ROE.

^[5] JS Global (2019). Pakistan Equity Strategy 2019. Karachi, January.

^[6] HUBCO and KAPCO (market share approximately 64 percent) revealed that they generated 11469 GWh in CY18 (13986 GWh in CY17).

^[7] Government introduced the Super Tax on individuals, association of persons (AOPs) and companies earning income above PKR 500 million in tax year 2015 at rate of 4 percent of income of banking companies and 3 percent on other categories for rehabilitation of temporarily displaced persons through Finance Bill (2015-16).
http://www.finance.gov.pk/

budget/budget_speech_english_2018_19.pdf

^[8] FED on imported vehicles amended from 20 percent on vehicles above 1800cc to 25 percent for vehicles between 1800cc and 3000cc, and 30 percent for 3000cc or above.

^[9] The short-term PD (1 Year PD) is mainly driven by the quality of firm’s liquidity management and ability to honor short-term obligations, while long-term PD (5 Year PD) is mainly influenced by solvency position and overall financial soundness of the firm.

^[10] State Bank of Pakistan is following a strategy to promote the rating culture through indirect measures.

In this regard, SBP requires banks and DFIs to hold higher capital against large exposures to unrated firms.

^[11] PACRA. (2019). Rating Scale. Pakistan, March. http://www.pacra.com.pk/

uploads/doc_report/PACRA_

Rating%20Scale_Corporate_FY18.pdf

^[12] World Bank. (2019). Doing Business 2019: Training for Reform, Economy Profile Pakistan. Pakistan, March http://www.doingbusiness.org/content/dam/

doingBusiness/country/p/pakistan/PAK.pdf

^[13] Pakistan Doing Business Reforms
http://boi.gov.pk/ViewNews.aspx?NID=3089

^[14] It is a digital central trade hub for clearance of cross-border consignments
https://www.thenews.com.pk/print/408956-pakistan-customs-green-signaled-to-implement-national-single-window

^[15] Eidleman, G. J. (1995). Z scores-A Guide to failure prediction. The CPA Journal, 65(2), 52.

^[16] The parameters of the model as identified in the original paper have been used to signal distress status of the firms and have not been calibrated to the local conditions. As such, the model may under/overestimate the distress factor. However, the current model provides a useful benchmark.

 

 

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6 Performance and Soundness of Financial Market Infrastructures

The country’s Financial Market Infrastructures (FMIs) remained efficient and resilient during CY18. Pakistan Real-Time Interbank Settlement Mechanism (PRISM) continued to handle larger volume and values of transactions, with an increasing share of third party fund transfers. On the retail segment front, consumers showed a growing preference for digital modes of transactions owing to the convenience it offers. Automated Teller Machine (ATM) downtime has continued to decrease, signaling lower operational risk in retail segment. Keeping in view the risks related to unregulated use of virtual currencies, SBP prohibited banks to deal in them. Further, comprehensive guidelines were issued during the year to ensure that the retail payments segment of the country remains resilient to cyber-attacks. Moreover, the securities clearing and settlement institutions of the country continued to enhance their risk management regime to ensure that financial markets continue to function in an efficient manner.

 

Financial Markets Infrastructures (FMIs) are critical components of financial system of a country. They comprise of important institutions, instruments and channels, which facilitate the process of financial intermediation by processing and recording the flow of funds and securities. Hence, the overall stability of the financial system is critically dependent upon their efficiency and resilience.

FMIs broadly cover the Payment Systems, Central Securities Depositories (CSD), Securities Settlement Systems (SSS), Central Counter Parties (CCPs) and trade repositories. ^[1] Pakistan’s major FMIs include large value payment system (LVPS) i.e. Pakistan Real-Time Interbank Settlement Mechanism (PRISM); one inter-bank switch (1-Link); one clearing house of paper-based instruments (NIFT); one corporate securities settlement company (NCCPL); and one corporate securities depository (CDC). The capital market infrastructures is regulated by SECP.

 

6.1 Payment Systems ^[2]

Payment Systems Landscape and Performance

Under its Vision 2020, SBP has set the “Development of Modern and Robust Payment Systems” as one of its key strategic objectives. Hence, it is continuously working towards the modernization of country’s payment systems and simultaneously enhancing its regulatory and supervisory regime to ensure their efficiency and resilience.

Based on the quantum of values transacted, the country’s payment system is divided into Large Value Payment Systems (LVPS) and Retail Value Payment Systems (RVPS). Pakistan’s LVPS, i.e. PRISM is used for wholesale transactions of both funds and government securities among its participants. Moreover, it is now increasingly being used for third party fund transfers. On the other hand, RVPS is composed of various paper-based and electronic channels used for retail transactions. Both PRISM and RVPS have shown a consistent increase in volume and value (Table 6.1).

PRISM remains efficient and resilient…

In line with the trend of CY17, PRISM has witnessed consistent growth in both volume and values. In aggregate, during the reviewed period, it has settled 65.37 percent of the total value of all payments, amounting to around 11 times of GDP.

The daily average volume of settled transactions has shown significant growth over the past year to reach 9,209 (CY17: 5,770), while daily average value has increased to PKR 1,563 billion (CY17: PKR 1,404 billion).

Overall, during CY18, volume and value of transactions settled through it grew by 59.58 percent and 11.34 percent, respectively. Encouragingly, the lion’s share of growth in volume and value came from Inter-bank Funds Transfers (IFT). It registered a growth of 65.68 percent in volume and 19.33 percent in value (Chart 6.1 and 6.2).

Within IFT, bulk of the growth has come from third party customer transfers. The trend of IFT is in line with the previous two years and is a result of continued efforts by SBP to popularize the use of RTGS system by banking consumers. In this regard, SBP has implemented straight-through processing via PRISM in 2016, whereby the core banking system of banks and PRISM system have been integrated to improve efficiency and minimize errors in payment processing. ^[3] Furthermore, SBP has allowed banks to use PRISM free-of-charge for same-day settlement of domestic transfers of home remittances to their beneficiaries. Consequently, use of PRISM for home remittances have seen a 63.56 percent rise in volume and 61.84 percent in value during CY18. This has garnered the trust of the banks and the banking consumers in the country’s RTGS system.

Over the past decade, PRISM has undergone significant developments with respect to its operations. New features such as 3^rd party fund transfers, straight through processing, interbank fund transfer of home remittances, membership of clearinghouses, CDNS, NCCPL etc. have been added to its functionality. Moreover, PRISM system was upgraded in CY17, which included enhancement in its features such as revised criteria for intra-day liquidity facility, improvement in reconciliation process and increased efficiency in managing funds and securities balance. To cater to these developments, SBP has issued new PRISM operating rules in March 2018, which incorporated these changes. Apart from this, the new rules have been aligned with Principles for Financial Market Infrastructures (PFMIs) issued by Bank for International Settlements, incorporating participation access criteria, settlement and finality, efficiency and effectiveness etc. ^[4]

Keeping in view the increasing risk of cyber-attacks, SBP has taken adequate measures to ensure that PRISM remains resilient. PRISM participants access the system through a private network, which is further safeguarded through dynamic multipoint network level encryption and a certification authorization system for generation of digital signatures and identity verification to cater to the risk of unauthorized access. Moreover, next generation firewalls for application and network filtering, robust malware protection and intrusion detection and prevention systems are implemented to mitigate the risk of cyber breaches. Further, to ensure that the PRISM system remains resilient to any system disruptions, SBP has maintained separate, well-functioning business continuity and disaster recovery sites which are tested frequently.

Retail Value Payment Systems post continued growth…

Comprising of paper-based and electronic modes of transactions, the retail payment systems of the country has also posted robust growth in volume and value of electronic transactions. The overall volume of transactions has surged by 10.33 percent whereas the value of transactions has increased by 3.17 percent (Chart 6.3). Within retail payments, the volume-wise share of paper-based transactions declined from 39.92 percent to 36.27 percent, which reflects the growing trend of e-banking transactions (Chart6.4). In terms of value transacted, paper-based modes still hold a major share in retail payments, accounting for 72.99 percent of value transacted.

Within the paper based transactions, Cheques remain the most popular instrument as they accounted for 50.85 percent of total volume and 75.70 percent of total value transacted (Chart 6.5).

Within cheque based transactions, major share of volume pertained to cash withdrawals amounting to 50.56 percent of total cheque transactions. However, the share of value remained low at 10.71 percent (Table 6.2). This points out to the possibility that banking consumers are using cheques for withdrawals of smaller amounts to avoid the cost of withholding tax on banking transactions, particularly by non-filers.

Non-cheque based transactions remain low in value

Non-cheque based transactions, which primarily reflect over-the-counter (OTC) cash transactions accounted for only 9.58 percent of the total paper-based value transacted. As banks offer ease of services such as utility bill payments and interbank funds transfers through their digital platforms, consumers are increasingly using these electronic channels against OTC transactions.

Electronic modes of transaction show healthy growth…

Electronic modes of transaction have been a major contributor to growth in retail payments during CY18. In line with the development in previous year, e-banking channels have shown robust growth in both volume and amount transacted. Overall, the volume of e-banking transactions has registered a growth of 17.01 percent, whereas the value of these transactions has increased by 32.33 percent to reach at PKR 53.67 trillion. The share of electronic transactions, within retail transactions, has increased to 27.01 percent in CY18 compared to 21.04 percent in CY17. This is a manifestation of the shifting trend towards these digital modes that offer greater convenience and efficiency of payments to consumers.

Among e-banking transactions, Real Time Online Banking Transactions accounted for 84.20 percent of the value transacted followed by ATM transactions, which amounted to 11.29 percent (Chart 6.6). With respect to volume of transactions, ATM transactions account for a major share (61.94 percent) (Chart 6.7).

Encouragingly, the share of alternate delivery channels (ADCs), particularly mobile and internet banking has been growing, albeit gradually. In terms of growth, internet banking posted a healthy growth of 33.23 percent in volume and 39.25 percent in value. In aggregate, PKR 2.1 trillion were transacted through internet banking, mobile banking and point-of-sale (POS) channels during CY18 as compared to PKR 1.6 trillion last year. This is reflective of the growing trust of banking consumers on alternate delivery channels offered by the banks.

Increasing investment in e-banking infrastructure…

Cognizant of the increasing adoption of e-banking channels, commercial and microfinance banks are increasing their investments in ADCs to tap into the growth potential as seen by an increase in online branches and ATMs. Furthermore, similar increase is visible in the number of credit and debit cards issued by banks (Table 6.3).

Paypak adoption continues in CY18…

In pursuance of SBP Vision 2020 and National Financial Inclusion Strategy (NFIS), 1-Link, with the approval of SBP, has launched the country’s first domestic payment scheme in 2016, with the aim to provide a low-cost, efficient and secure payment solution. ^[5] Since its launch, Paypak has made significant inroads in the payments landscape of the country, which is evident by its increasing adoption. A total of 18 banks (14 commercial banks and 4 microfinance banks) have issued around 1.12 million cards as of December, 2018 as compared to 0.75 million cards at the end of CY17.

SBP has issued comprehensive guidelines for retail payments in the wake of rising cyber-attacks…

Rise in threats of cyber-attacks is a global phenomenon. World Economic Forum’s Global Risks Report, 2019 also mentions cyber-attacks as one of the top 10 risks in terms of both likelihood and impact. As more and more customers start adopting electronic modes, electronic channels have become a target for cyber-criminals. Results of the 3^rd wave of the SBP’s Systemic Risk Survey also points out that the respondents have rated cyber security risk as one of the top 10 risks for the financial sector (See Box 1).

In the wake of increasing threats of cyber-attacks, SBP has issued a comprehensive circular on security of digital payments to safeguard banks and their customers from potential losses. The circular includes measures such as extensive vulnerability assessment and penetration testing of banks’ technological infrastructure to identify potential weaknesses in their ADCs and payment systems. Furthermore, it has been made mandatory for banks to provide free of cost SMS and email alerts with respect to both domestic and international digital transactions to their customers, serving as a detective control in case of a cyber-attack or fraud. Further, the circular entails deployment of real-time fraud monitoring tools and alert mechanisms by banks for the detection of fraudulent activities and dissemination of education to customers regarding types of online banking frauds^{. [6]}

In order to mitigate the risk of payment-card related frauds such as skimming, SBP has already instructed the banks to issue secure cards which are compliant with Europay, Mastercard and Visa (EMV) Standard and replace all the existing cards with chip-and-PIN payment cards by December, 2019^{. [7]}

ATM downtime reduces further…

ATMs possess the highest share in volume of e-banking transactions and is a medium, which is designed to be available round the clock. Hence, they are critically important infrastructures and any disruption in their working due to banks’ system failure, poor connectivity, power outages and inadequate cash replenishment may lead to operational as well as reputational risk for the banks. Owing to improved surveillance and concerted efforts of SBP, the downtime of ATMs has reduced further during CY18, indicating improved efficiency (Chart 6.8).

Settlement and liquidity risks in retail payments are managed effectively…

Since Pakistan’s retail payment segment works on Deferred Net Settlement (DNS) basis i.e. T+1 basis, it entails creation of overnight credit risk before a transaction is settled the next day. Various safeguards are in place both by banks and SBP. Banks have imposed per day transfer limits for both retail and corporate customers. On the other hand, SBP has imposed cash reserve and statutory liquidity requirements on banks to ensure that sufficient liquidity is available in their accounts with SBP BSC to cover the settlement amount. Moreover, since the transactions are settled in PRISM, the availability of intra-day liquidity facility (ILF) assuages the liquidity risk as well. 

Branchless Banking, shows continued growth…

Branchless banking is another key element of the retail payments landscape of Pakistan. It serves as a catalyst for financial inclusion and has tremendous potential to expand the outreach of financial services to the financially excluded populace. Continuing its growth trend, number of branchless banking accounts, deposits and number of transactions have registered robust growth during CY18 (Table 6.4). To cater to customer due diligence (CDD) risk related to branchless banking transactions, SBP has put in place extensive requirements such as verification of customer particulars from NADRA, biometric verification, transaction and maximum balance limits. ^[8]

SBP continues to promote innovations while managing risks…

SBP is encouraging Payment System Operators (PSOs) / Payment System Providers (PSPs) such as payment aggregators, electronic wallets and e-commerce gateways, which will add value to the payments landscape of the country. Such non-banking technology-based firms provide various services such as clearing, routing, switch services and electronic facilitation of payments, thus providing efficiency and convenience to customers. In this regard, SBP has issued detailed Rules for Payment System Operators and Payment Service providers. ^[9] These regulations are aimed at encouraging their growth, managing risks, and bringing them into the regulatory ambit.

CY18 has also witnessed a growing interest in virtual currencies around the globe and in Pakistan, followed by regulatory actions in various jurisdictions. These virtual currencies saw huge bouts of volatility in their value during the reviewed period. Keeping in view the growing regulatory concerns, escalating price volatility and supervisory actions around the globe, SBP has advised all Banks/MFBs/DFIs/PSO/PSPs against dealing in them. ^[10] It is pertinent to mention that SBP has been proactive in monitoring and managing the risks associated with the use of virtual currencies as evident from the fact that SBP and SECP had also previously issued a joint Public Warning, in September, 2016, cautioning the public about using Bitcoin and other virtual currencies.

Some of the risks that virtual currencies may pose include: a) significant price volatility associated with speculative activity, which may prove to be harmful for the uninformed investors; (Chart 6.9) b) failure/closure of virtual currency exchanges/businesses due to any reason including action by law enforcement agencies; and c) hacking/security compromises of crypto currency exchanges and wallet businesses as a number of instances were recorded around the world where huge amount of funds have been lost due to the exchange/wallet operations being hacked/compromised. However, SBP remains open to technological innovations (including distributed ledger technology) which can enhance the efficiency of financial services. It continues to explore possible uses of technologies while keeping in view integrity, stability and consumer protection concerns of the financial sector.

Managing Systemically Important Payment Systems (SIPS)…

Payment systems are at the core of a financial system. Owing to their importance, any disruption in processes or flaw in their design can result in emergence of systemic risk. In view of this, SBP has already improved the oversight of some of the payment systems such as NIFT and 1-Link. Under the Payment Systems Designation Framework issued by SBP, it is finalizing the designation, which will allow it to perform closer supervision of SIPS. ^[11]

6.2 FMIs other than Payment Systems

NCCPL aligns its risk management regime with its role as CCP…

NCCPL has become a systemically important FMI, keeping in view its assumption of the role of Central Counter Party (CCP) in May 2016. Dealing with the settlement of trades in the capital markets, it took various measures to enhance the efficacy of its operations and strengthen its risk management regime.

It became a special participant of PRISM in January 2018 enabling the efficient settlement of NCSS transactions. Instead of settlement through multiple settlement banks, the transactions are now settled via PRISM in the form of multilateral net settlement batches (MNSBs), thus reducing the operational risk. Furthermore, multilateral netting also mitigates the liquidity risk posed to the broker clearing members (BCMs).

In order to placate the settlement risk arising due to potential default of any member, NCCPL maintains a Settlement Guarantee Fund (SGF). The fund was valued at PKR 2.75 billion at its inception and witnessed a gradual accretion of 6.0 percent over the current year to reach at PKR 3.28 billion in December, 2018. However, the daily average settlement value for the year stood at PKR 5.7 billion, which is greater than the value of fund (Chart 6.10). Although the margins provided by clearing members are the first line of defense against default risk, SGF provides a buffer against emergence of systemic issues in the capital market.

In view of its role as a CCP, NCCPL has augmented its risk management regime during CY18. Initially, the risk management system of PSX was employed by NCCPL. Effective from 30^th July, 2018, NCCPL has implemented its own in-house risk management system. Besides having similar features, the new system would enable NCCPL to efficiently supervise the risk profile of clearing members and employ adequate safeguards against the emergence of settlement risk, if any.

Custodial risk remains low…

CDC is another key FMI, which acts as the central securities depository (CSD) of the country. It manages and operates the Central Depository System (CDS), which is an electronic book-entry system used to record and maintain securities and register their transfers. Hence, it performs a two-pronged function i.e. the facilitation of trade in securities and management of the custodial risk associated with it.

CDC continues to hold the trust of the general public as evident by the increasing number of investor accounts, which stood at 53,896 at the end of CY18. The CDS handled a total of 138 billion shares with a market capitalization of PKR 4.7 trillion at the end of the reviewed period. ^[12]

In terms of facilitating the market, CDC has undertaken numerous measures, which include establishment of the Centralized e-IPO system, MAccess-CDC Access Mobile Application-that offers the investors convenience of managing their accounts through mobile phones and an eDividend repository in line with provisions of Companies Act, 2017. ^[13]

Being an electronic book-entry system makes CDS vulnerable to IT security risk. To ensure the safety of investor’s assets, CDC has put in place sufficient safeguards. This is evinced by the fact that it is an ISO 27001 certified company, ensuring that it has adequate controls in place to ensure information security. Moreover, it has also obtained ISO 22301 and ISAE 3402 certifications, which deal with business continuity management and internal controls. Further, CDC has partnered with 1Link to add the feature of IBAN validation and title fetching mechanism in CDS to ensure synchronization of account titles, thus reducing the operational risk.

Increasing interconnectedness and cybersecurity issues needs joint supervisory attention…

With each year the country’s FMIs depict a growing level of interconnectedness. On the one hand it results in efficiency gains in terms of their usage and increasing expediency to consumers, whereas on the other hand, it can potentially pose a higher level of systemic risk. Coupled with this, the global emergence of cyber-security risk may pose a challenge to the smooth and efficient working of these FMIs. Going forward, managing these risks will require further strengthening of entity-level risk management regimes along with regulatory coordination between SBP and SECP. In this regard, Council of Regulators (CoR), a forum for regulatory collaboration, is already actively working.

 

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^[1] An FMI is defined as a multilateral system among participating institutions, including the operator of the system, used for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions. Committee on Payment and Settlement Systems of BIS, (2012), “Principles for Financial Market Infrastructures”.

^[2] By virtue of the powers entrusted to it, SBP plays the role of regulator, operator and facilitator of Pakistan’s payment systems. Article 3 of the Payment Systems and Electronic Funds Transfer Act (PSEFT), 2007, endows upon SBP the power to regulate the country’s payment systems to ensure their soundness, possible emergence of systemic risk and interests of the general public.

^[3] PSD Circular No. 2 of 2016;

http://www.sbp.org.pk/psd/2016/C2.htm

^[4] Payment Systems Review FY18

^[5] The scheme is operated by 1-Link.

^[6] PSD Circular No. 9 of 2018;

http://www.sbp.org.pk/psd/2018/C9.htm

^[7] PSD Circular No. 5 of 2016;

https://www.sbp.org.pk/psd/2016/C5.htm

^[8] BPRD circular No. 9 of 2016;

https://www.sbp.org.pk/bprd/2016/C9.htm

^[9] PSD Circular No. 3 of 2014;

http://www.sbp.org.pk/psd/2014/C3.htm

^[10] BPRD Circular No. 3 of 2018;

http://www.sbp.org.pk/bprd/2018/C3.htm

^[11] PSD Circular No. 2 of 2017;

https://www.sbp.org.pk/psd/2017/C2.htm

^[12] CDC Newsletter, Oct-Dec, 2018

^[13] CDC Newsletters, Jan-Dec, 2017

 

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7 Financial Inclusion and Financial Stability

Pakistan has come a long way in financial inclusion as today branchless banking and m-wallet accounts have expanded the access to far-flung areas of the country. The Microfinance banking sector, the key actor in financial inclusion landscape, continues to perform exceedingly well even in the face of general slowdown in the economy in CY18. MFBs asset base, deposits, advances have shown promising growth and the CAR has improved. From the financial stability perspective, growing financial inclusion poses limited concerns.

 

Pakistan re-launched the National Financial Inclusion Strategy with renewed commitment during 2018…

Pakistan is one of the pioneers in providing an enabling and conductive policy and regulatory framework for financial inclusion. Considering the benefits associated with enhanced financial inclusion (See Box 6), its longstanding commitment to inclusive finance was stepped up into a comprehensive National Financial Inclusion Strategy (NFIS) in 2015. 

NFIS is based on four drivers: (i) promoting digital transaction accounts and reaching scale through bulk payments, (ii) expanding and diversifying access points, (iii) improving capacity of financial service providers, and (iv) increasing levels of financial awareness and capability. Under each category, a set of targets have been identified that are to be achieved by the year 2020. With the renewed commitment of the new government, the magnitude of various targets of NFIS have been revised during 2018, under the 100-days agenda, and the deadline has been extended to 2023 (See Exhibit)

NFIS envisages utilizing all possible channels…

A common misconception is that only Microfinance institutions are responsible for banking the unbanked. However, all financial institutions including banks and non-banks have their role to play in enhancing financial depth and breadth. This is the reason that NFIS has envisaged utilization of all possible channels for increasing access.

Commercial banks facilitating in Financial Inclusion agenda, though at a slower pace …

To achieve the targets set under NFIS, the banks are also aiding by expanding the branch network, deposit base and financing to SME, Housing and Agriculture sectors. During CY18, banks have increased their branch network by 5 percent to 15,346. ^[1] Under SME financing, the number of borrowers have increased by 8.7 percent to 177,796 while financing has grown by 12.39 percent.  

Housing finance, however, has decelerated recording a growth of 21.62 percent in CY18 compared to an increase of 31.85 percent in the previous year. Among others, the challenging economic environment seems to be having an impact on housing finance. Nevertheless, the number of borrowers have inched up by 9 percent to reach 16,320 in CY18. Agriculture financing, on the other hand, has reduced by 2.44 percent in CY18 (See Chapter 3.1).

SBP, cognizant of the need to keep up the pace of NFIS, has taken several measures to promote priority sector financing. It has provided indicative targets to the banks & DFIs to achieve the goal of SME financing equivalent to 17 percent of total private sector credit by 2023. In case of low cost housing, SBP has announced “Financing Facility for Low Cost Housing for Special Segments” at concessional rate. ^[2] Further to its efforts, a National Financial Literacy Program (NFLP) has been launched.

 

The Microfinance sector is the biggest player of financial inclusion landscape in Pakistan…

Microfinance Banks (MFBs) remains a pivotal player in the financial inclusion landscape in Pakistan. MFBs constitute almost 70 percent of the total loan portfolio of the microfinance sector followed by Microfinance Institutions (MFIs) with 20 percent share. ^[3]

The assets of MFBs have increased by 32.7 percent during the CY18 compared to a 7 percent increase in assets of commercial banks (Table 7.1 & Chart 7.1). Accordingly, share of MFBs’ assets in the total banking sector assets has reached to 1.62 percent in CY18 from 1.31 percent in CY17 (0.57 percent in CY14).

Advances of MFBs have recorded a healthy growth of 38.6 percent during CY18, while number of loans have increased by 40 percent to 2 million. As a result, the share of MFB loans has increased to 2.25 percent of banking sector loans in CY18 as compared to 1.99 percent in CY17.

MFBs are effectively playing the intermediary role as the ADR improved by 5.7 percentage points to 77.7 percent in CY18. This improvement, among other factors, has come on the back of 20 percent growth in the number of MFBs clients, which   have increased to 3,169,785 in CY18.

The microfinance banking sector is maturing…

The MFBs started their business with group lending model. Over the years, the financing model has shifted from the solidarity groups to individual lending. At the end of CY18, the share of individual financing in total financing has reached to 71.76 percent from 65.14 percent in CY17. This increase is attributed to maturity attained by microfinance industry and the development of effective borrower assessment criteria. The adoption of technology by MFBs and increase in financial literacy among the lower income strata is also helping MFBs to focus on individual lending rather than group lending.

 

The deposit growth momentum accelerates helping MFBs attain self-sufficiency in funding…

The deposit base of MFBs has been expanding helping them achieve self-sufficiency in their funding requirements (Table 7.1). During CY18, the deposits have increased by 28.37 percent in comparison to 54 percent in CY17. Encouragingly, the composition of deposits is tilting towards individuals who now have 58 percent share in total deposits, while the institutions account for about 36 percent. The increase in deposits from individuals has recorded another increase of 23 percent during CY18. This high growth trend has facilitated in providing a more stable and steady funding to MFBs.

…though concentration in deposits is still relatively high

The healthy growth in deposits as well as the change in its composition is encouraging because it is supporting the asset growth. However, the concentration in deposits of MFBs remains relatively high as the top 25 depositors constitute around 35 percent of the total deposits.

Despite some dip in profitability, capital adequacy of MFBs has improved ….

The profitability of the MFBs has observed some decrease during CY18 despite rise in earning assets. This is mainly due to increase in provision expense resulting from high defaults in MFBs’ exposure to sugar sector. As a result, the profitability indicators have dipped during CY18 (Table 7.1). The CAR of MFBs has, however, improved by about 1 percentage point to 22.65 percent in CY18. Injection of fresh capital and rise in retained earnings and reserves contributed to the improved CAR. (Chart 7.2).

Expansion in Digital Financial Services (DFS) is changing the financial landscape…

With the advancements of new technologies, the scale of disruption in the banking industry is unprecedented across markets, distribution channels and product lines. Significant penetration of digital channels like mobile phone, smart cards, internet, and other technologies are resulting in new innovative business models that deliver financial services at lower prices, efficiently and with broader customer reach.

SBP has taken various initiatives in recent past for promotion of digital payment channels in the country. Some of the measures include: development of a strong legal and regulatory framework; robust payment systems infrastructure; Real Time Gross Settlement (RTGS) system; fully interoperable ATM switches; fast growing internet, mobile and branchless banking services along with plastic cards (ATM only, Debit, Credit and Pre-Paid cards). All these initiatives are opening new areas of possibilities in the Business-to-Business (B2B), Business-to-Customer (B2C), Government-to-Person (G2P) payments and Person-to-Government (P2G) payments. Because of these efforts, the share of digital payments is trending upward in Pakistan. (See Chapter 6). Currently, the share of e-Banking channels i.e. real time online branches (RTOB), ATMs, e-Commerce, Internet, Mobile Phone and Call Centers/ IVR Banking in total transactions processed is around 8 percent.

In order to foster innovation in the payments industry and promote financial inclusion, SBP has issued the regulations for ‘Electronic Money Institutions’. ^[4] Under these regulations, SBP has decided to license non-banking entities as E-Money Institutions (EMIs). Likewise, an “Innovation Challenge Facility” has been launched in May 2019 to facilitate stakeholders to develop innovative digital solutions ^[5] .

Branchless Banking, the core of DFS, is continuing its growth momentum…

With the advent of Branchless Banking (BB) and M-wallet accounts, MFBs have gradually leveraged the potential of reaching to masses without physical outreach through brick and mortar branches. Rapid outreach and lower operational costs have accelerated the growth of branchless banking. Especially, the launch of the Asaan Mobile Account (AMA) Scheme will further enable account opening and usage of financial services through an interoperable platform for the low income demographic. ^[6] A look at the performance of BB during the CY18 reveals that the positive momentum of growth in the number of accounts has continued recording 26.58 percent growth and reaching to 47 million during the year. Similarly, the BB deposits have grown by 12 percent during the year (Table 7.2).

On the usage front, the number of transactions during the period and the average number of transactions per day have shown growth of 47 percent and 41 percent, respectively, during CY18.

SBP cognizant of its responsibilities has put in place a robust risk-based customer due diligence approach to ensure that the integrity of the branchless banking channels. Based on the category of account, the Customer Due Diligence (CDD) requirements include verification of customer particulars from NADRA, biometric verification, transaction limits and maximum balance limits. ^[7]

There is still untapped potential for the BB players….

Despite the sustained growth in BB sector there is still a plenty of untapped potential to expand further the BB services in the country. Creation of an interoperable digital ecosystem, enhanced financial literacy, promotion of products and registration of new users, expanding the value added services in the product offerings are some of the challenges that BB players need to overcome to maximize true positive impact of digital financial services.

The expanding financial inclusion poses limited financial stability concerns…

There is growing evidence in the literature that financial inclusion can have mixed effects on the financial stability of the system. Some of the positive effects include broadening of banking industry’s assets, diversifying its depositor base and better transmission of monetary impulses etc. ^[8] On the contrary, risk level may rise from rapid credit growth associated with new financial inclusion institutions and instruments, and from inadequate or lack of regulations especially in view of rapid acceleration in digital financial services.

Since in Pakistan, the strategy for financial inclusion is supported by a well-defined regulatory and supervisory architecture and the risk-based customer due diligence (CDD) the negative externalities arising from the increase in depth and breadth of financial services are limited.

Way forward…

The revised NFIS targets, including the gender balance, set under the 100-day agenda of the current government require concerted efforts of all stakeholders. Therefore, there is a need to remain engaged with them to achieve the common goals.

Box 7: Financial Inclusion

Financial inclusion has been established as a universal mean to deliver a suite of useful, cost effective and quality financial services to unbanked individuals and businesses in order to meet their needs of transactions, savings, payments, credit and insurance etc. The concept of financial inclusion has evolved over the time. It goes beyond the simple concept of opening new banking accounts to having access to a full suite of quality financial services.

Enhancing the breadth and depth of financial services can significantly contribute in poverty alleviation, uplifting living standards, reduce income inequality and provide resilience to absorb financial shocks. Despite the integral part of financial inclusion in grass root development, majority of people have either no or limited access to quality financial services especially in developing countries.

In order to reap the aforementioned benefits, policy makers focus on increasing access, usage and quality of financial services by providing enabling prudential and legal framework to the practitioners.

Policymakers to enhance financial inclusion broadly focus on three key areas i.e. Access, Usage and Quality.

Access….

According to Findex database 2017, 1.2 billion people have gotten formal access to a financial account since 2011. Of this more than half a billion people have gained access in the last three years.

Though there are tangible gains in financial inclusion over the last few years (Chart 1), however, almost one–third of the global adult population i.e. 1.7 billion adults, still do not have a formal bank account. ^[1] The identified reasons for low financial inclusion includes mistrust of people on financial institutions, capacity and ambition of financial services provider to reach large scale. ^[2]

Access to a basic transaction account is considered a gateway to broader financial inclusion since it allows people to come in contact with financial services like sending, receiving and storing of money. It is more likely that people will use other financial services like insurance and credit once they become accountholders.

Technology and rapid innovation in digital financial services have been great drivers of access and inclusion. GSMA calculates that around 1.3 billion dollars’ worth transactions are processed through mobile phones in 90 countries every day. ^[3] The extensive use and capabilities of mobile phones and access points have transformed the concept from requiring people to physically accessing financial institution into brining financial access to their doorsteps.

Usage…

A head start on access to financial services is a good step in the first place, however, it is not enough to contribute positively to the financial capability of the poor. Using a financial account is different from only having it. Findex, 2017 data shows that globally around one-fifth of the accounts remained inactive, no deposit or withdrawal were made, during the past 12 months. Countries like China, Thailand and Kenya have expanded their financial access to more than 80 percent. However, with increased focus on the financial access an even greater focus is needed on the usage of these accounts.

The introduction and usage of digital technologies has increased financial inclusion as it lowered the costs of initiating and maintaining financial relationships for both institutions and consumers. Overcoming challenges such as digitizing the government to person transfers and wages can help in improving the access and usage of the accounts.

Quality…

Customization and development of financial products and services to cater to the needs of the poor and the first time users is another important dimension integral, for improvement in financial inclusion. Targeting segments like women and poor living in the rural areas with quality and tailored financial products can augment the access and usage of the financial inclusion.

Financial capability is the knowing and understanding of how to use the available financial service that plays an important role in building a wholesome financial inclusion experience. Products based on technology ideally should be simple, convenient, reliable, and friendly. Coupling the provision of quality and customized products with increasing the financial capability of the customer can lead to better financial inclusion impacts.