The quiet success of bank privatisation

Supreme court's decision to reopen the loan defaults cases could damage the banking sector.

With the revived judicial scrutiny of loan default cases in the Supreme Court, some dating back to the early 1970s, the credibility that the financial services sector has built up over the past decade stands to be severely compromised.

This article will examine what the banks and their regulators achieved since the privatisation process began in 1991, how reopening the loan defaults cases could damage the banking sector and how the worst may still be avoided.

Privatisation: when the government steps aside

Perhaps the single biggest economic success of the government over the past two decades has been the near-total privatisation of the banking sector. This success has played a large role in the growth of the economy, particularly over the last decade and has been crucial in the development of a vibrant entrepreneurial middle class that is beginning to emerge in Pakistan’s urban centres.

The transition from a sclerotic, state-owned financial system to a vibrant, if at times over-exuberant, banking and capital markets sector took just over a decade. It began with the privatisation of Allied Bank in 1991, the smallest of the “Big Five” banks and can logically be said to have reached its conclusion with the completion of the Habib Bank privatisation in December 2003.

Over those 12 years, the banking sector went from being more than 92% government-owned in terms of assets to being more than 82% privately-owned. In the period since then, financial services in Pakistan have seen a boom, a severe crunch and then a carefully managed bounce-back.

Between 2001 and May this year (the latest month for which figures are available), the banking sector has seen its assets grow by an average annual rate of 18.4 per cent. Even when adjusted for inflation, that comes out to a healthy 7.9 per cent average real growth rate.

Before privatisation, banks had been highly politicised institutions, with loans being made for non-commercial reasons and many highly-connected borrowers being able to get their loans written off entirely, often without any asset seizures or other consequences.

Banks frequently had non-performing loan ratios well over 20 per cent of their total lending, requiring the government to constantly bail them out. As of June this year, that ratio has come down to 3.8 per cent.

The loan defaults case

During the privatisation process, the government strengthened banks’ balance sheets by injecting them with Rs46.6 billion in equity and moving Rs47.4 billion in non-performing assets off their books and into the Corporate and Industrial Restructuring Corporation (Circ), a specially created vehicle to handle some of the worst NPLs. It also downsized the workforce of the banks by over 28 per cent.

These and many more measures worked: bank privatisation was a highly competitive process in which many strong investment groups bid for local banks and stock market listings were frequently heavily oversubscribed. The government made back more than the money that it invested in strengthening the financial institutions.

However, not all of the bad assets were moved to the Circ. Many were simply written off. If the cases against defaulters are opened up, the banks that wrote off the loans and moved them off their books will have to move them back on to their balance sheets.

Having billions of rupees worth of bad loans suddenly reappear will make their capital adequacy ratios look insufficient, requiring them to raise more capital in an environment where it is difficult to do so.

Indeed, several banks are already in violation of the central bank’s requirements on total paid up capital, a measure of the bank’s financial strength. The largest five, which have the worst legacies of NPLs, have been a pillar of strength in such a time of economic turmoil. Yet if they are forced to try and recover decades-old loans, their otherwise strong positions will be compromised and they will be forced to cut back lending in order to shore up their capital reserves.

This reduction in lending will further slow down the economy at a time when it needs all the stimulus it can get.

CIRC: a way out

The Supreme Court’s objective of trying to remove all vestiges of privilege is a noble one. But trying to recover decades-old defaulted loans is akin to reopening wounds after a surgeon has painstakingly sealed them.

Yet, if they must proceed with this case, there may be a way to balance the needs of the banking sector’s stability as well as punishing those who got away with the economic equivalent of murder.

The government, through the State Bank of Pakistan, can stipulate that all of the loans currently being adjudicated in court will be moved to the CIRC and not on the individual balance sheet of any bank.

After all, it was the government that paid for these loans through its constant bailouts of the banks in the 1980s and 1990s. It should be the beneficiary of any loans recovered. Such a strategy would also remove the pall of uncertainty that would inevitably hang over the banking sector while the loan recovery process drags on.

The writer is a financial and management consultant based out of Karachi

Published in The Express Tribune, October 25^th, 2010.