SBP warns of banking sector’s reliance on government borrowing

KARACHI: The State Bank of Pakistan (SBP) said on Monday the banking sector’s exposure to the government remains high, requiring serious measures to reduce its reliance on banks for fiscal needs.

The SBP's mid-year performance review of the banking sector said that the industry is expected to maintain its steady performance in the second half (July-December) of 2023, with a major expansion in the balance sheet likely to be driven by investments due to the anticipated borrowing requirements of the government.

"The performance of the banking sector in H2CY23 depends on the operating environment and evolving policy stance," the SBP said. "The macroeconomic environment remains challenging primarily due to subdued economic activity and elevated inflation."

"Moreover, as a result of stabilization measures, domestic financial conditions have considerably tightened. However, business confidence may revive after the recent IMF’s Stand-By Arrangement (SBA)," it added.

"In this backdrop, the banking sector is expected to continue its steady performance," it said and added that major expansion in the balance sheet is likely to be driven by investments owing to expected borrowings needs of the government. The SBP expects advances are also expected to post their seasonal uptick towards the end of 2023, as credit demand from sectors such as textiles and sugar increases in the fourth quarter of this year.

The banking sector’s review highlighted that the macroeconomic environment continued to remain challenging during the first half of 2023. Domestic financial conditions tightened while the operating environment remained under stress due to elevated inflation and prolonged uncertainty. Nonetheless, the banking sector’s balance sheet expanded by 14.0 percent during the first half (January-June) of this year. The expansion in the asset base was mainly driven by investments in government securities.

Besides a strong inflow of deposits, banks’ reliance on borrowings remained noticeable during the period, it noted. As the impact of the increase in interest rates will continue totranslate into returns on earning assets in the months to come, the SBP expects the operating performance of the banking industry to remain stable. High-interest expenses, however, can limit earnings.

The steady earnings are expected to support the solvency position and improve the capital adequacy ratio, according to the review. “Overall economic stabilization policy to contain aggregate demand and stressed financial conditions could involve credit risk concerns for banks, however, banks’ asset quality is likely to remain firm, as their major lending is tilted towards corporate borrowers which have better credit worthiness and cushions to withstand economic shocks,” it said.

“However, the banking sector’s exposure to government remains high which demands earnest measures to reduce the reliance on the banking sector for fiscal needs,” it added. The SBP in a statement issued on the same day said that advances of the banking sector recorded a muted growth during January-June; private sector advances contracted while the public sector availed additional financing mainly for commodity finance operations. Encouragingly, asset quality indicators improved: net non-performing loans to loans ratio lowered to 0.45 percent at the end of June 2023 (0.68 percent in June 2022) as banks set aside higher amounts of provisioning from steady earnings.

Profitability indicators witnessed noticeable improvement as return on assets improved to 1.5 percent in the first half (1.0 percent for 2022). The higher earnings in turn also helped to improve the capital adequacy ratio of the banking sector to 17.8 percent by the end of June 2023 (17.0 percent at end Dec-2022). With further improvement in solvency indicators, the ability of the banking sector to withstand a set of severe hypothetical shocks further improved as indicated by the latest stress testing results, according to the SBP.

The review also covers the results of 12th wave of SRS (July 2023), which suggest that the key potential risks faced by the financial system include foreign exchange risk, increasing domestic inflation, and political uncertainty. The respondents, however, expressed confidence in the stability of the financial system and the ability of the regulators.