Pakistani banks have long been criticized for making risk-free money by investing into securities, backed by Government of Pakistan, which remains their single-largest borrower for over a decade – those golden days seem to be over since there are no easy bucks now.

The bankers’ ability to make money was tested in mid-2015 when the State Bank of Pakistan, the apex regulator, started reducing its monetary policy rate, taking life out of the otherwise lucrative Pakistan Investment Bonds (PIBs): the biggest investment avenue for the country’s banks in recent years.

The banking sector’s earnings remained flat last year, courtesy three-year PIBs, which reached maturity in mid-2016 and ate up most of their earnings.

Banks had invested a major chunk, about 30% or Rs1.2 trillion of their deposits into PIBs at a much higher rate of 12% three years ago, said Umair Naseer, Senior Research Analyst at Topline Securities. After these bonds reached maturity, the banks had to reinvest the money in new PIBs at less than 6%, which dented their profit margins, he added.

“The core banking side is at a historic low,” Insight Securities’ Head of Research Zeeshan Afzal said referring to the central bank’s policy rate, which is hovering at 5.75% since May 2016, its lowest level in the last 42 years. Low-interest rate environment is currently the biggest challenge facing the banking sector, the analyst said.

The SBP’s policy rate is the rate at which commercial banks borrow from the central bank’s discount window on an overnight basis. Simply put, it affects every other interest rate in the market.

Explaining the phenomenon to Profit, senior banker and former Finance Minister Shaukat Tarin said, “The government has been borrowing heavily for the past several years, and the banks have become used to investing in the government paper.” The government had been issuing three-year, five-year, and 10-year PIBs for the past few years on a higher rate as compared to those offered by one-year Treasury bills, the banker said. This ‘incremental spread’ gave the kicker to banks as most of them are sitting on large deposits. Since there are quite a few branches, and the cost of funds was very low, they [banks] were making between 5% and 7% risk-free spread during these years, he added – no wonder, more than 60% of banks’ advances were parked in the public sector at one point.

However, banks’ earnings were affected after the discount rate started coming down in 2015, Tarin said. On the other hand, the government also worked to consolidate its fiscal position, bringing down fiscal deficit, that is the government’s appetite to borrow also came down, he added.

The market analysts Profit spoke to couldn’t agree more.The downward revision of interest rates is also the reason why banking spreads have shrunk to their lowest level in over a decade. With the exception of Standard Chartered Bank Pakistan, no other bank had a net interest margin of over 5% last year – a bank’s spread or net interest margin is the difference between borrowing rate (how much banks pay to depositors) and lending rate (how much banks charge from borrowers). In other words, it is the bank’s equivalent of profit margin thus the higher the spread, the more it earns.

Because of compressed banking spreads, nearly half of the 25 banks we studied for this report saw their operating profits decline during the period, a trend that is likely to continue this year.

“The driving engines of any bank depending on their strategy are either the corporate business or the SME business or the consumer business,” Tarin says, which begs the question: why would banks invest so heavily in long-term government paper?

“Credit offtake has remained low since 2012 as loans were not increasing,” says Syed Fawad Basir, Senior Investment Analyst at Arif Habib Limited. According to market analysts, banks’ reluctance towards lending to the private sector was partly due to the risk of defaults. Many borrowers – including some big shots – had defaulted on their payments following the financial crunch of 2008-2009, they say. That resulted in higher non-performing loans (NPLs) growth for banks, which were discouraged from further lending to the private sector.

The outliers

Lower PIB yields, poor credit offtake and little investment opportunities kept banks’ earnings under pressure, but they also pushed the best out of them. Bankers have been trying to weather the storm through improved cost efficiencies, quality of assets, and quality of their balance sheets. They have also shifted focus back on consumer financing. Despite pressures on profitability, the banking sector, in its entirety, remained on the growth track, with most banks witnessing double-digit growth in both their deposits and advances last year. In this report, Profit takes a look at how some of these banks delivered strong financial performances in a challenging environment.

“The idea is to capture and appreciate the growth observed in banks, while not ignoring the balance sheet and operational quality,” said Abdul Ghani Fatani, an Investment Analyst at Intermarket Securities who dug into the balance sheets of these banks to compile three-year old data for this study.

Explaining, the analyst said banks sought support from cost efficiencies, improved non-performing loans (NPLs) recoveries and higher current account savings account (CASA) balances to limit earnings depletion in 2016.

For example, Fatani said four large private banks witnessed 12% growth in advances last year compared to 2015, backed by the recovery of working capital financing and robust long-term credit. Investment growth decelerated as banks showed a slight shift in focus towards T-bills and deposits base increased by 13% last year on the back of improvement in domestic CASA (current account saving account) balances across the board, he noted.

Before we get into what challenges lie ahead, let’s take a look at some of the banks that performed exceptionally well last year.

National Bank of Pakistan: a turnaround story in the offing

One example that explains the improvement in the quality of assets is National Bank of Pakistan, which surprised the market by booking its highest-ever after-tax profit to date – NBP’s net earnings clocked in at Rs23 billion, which was well above market consensus.

With core earnings not improving, the state-owned banking giant demonstrated improved asset quality, loan growth and cost control last year. It booked a loan provision reversal of Rs2.25 billion in the last quarter of 2016 for the first time since 2007, according to Intermarket Securities. The bank saw its NPLs drop by 6% in the outgoing year, which helped it increase operating profit (net profit before tax) by 10% in the year. Tier-I return on equity (ROE) clocked in at 19%, its highest level since 2009 and close to that of top-tier banks.

NBP was a top performer in the last three years, says Naseer from Topline Securities. Being a state-owned bank, NBP’s major problem was recoveries. For example, it may benefit from certain government projects, but also faces high NPL as credit to public-sector entities is often hard to recover, he adds. “NBP has done well on that front [recoveries], which translated to recurring income.”

However, not all analysts seem to agree on NBP’s performance being a function of core banking“National Bank certainly had a stellar run last year, but one should also look at where this growth came from,” Basir of Arif Habib Limited said. “For example, they booked Rs10 billion reversal from NPLs, which is not core earnings,” he added – Profit’s queries to NBP were not entertained.

Innovation, network expansion, increased financing power Meezan’s northbound journey

The expansion in Meezan Bank’s branch network helped improve their deposits while double-digit growth in Islamic banking, a new segment which is growing significantly also helped Meezan, analysts say.

One of the major distinguishing factors in Meezan’s case was not investing in PIBs since it’s an Islamic bank and doesn’t invest in securities that are not Sharia compliant, analysts say.

However, the leadership of the fastest growing Islamic Bank seems to have a different take on reducing policy rates.

“For Islamic banks, this has translated into greater challenges given the shortage of liquidity instruments available,” President and CEO, Meezan Bank Irfan Siddiqui said in an email response to Profit.

Asked how the bank was able to perform well under these challenging circumstances, the CEO said Meezan’s recent success was due to a myriad of efforts.

“We have recently embarked on the aim of further strengthening our technological backbone. To give an example, we have recently deployed the Oracle Exadata Database Machine to cut the close of business time by 30%,” Siddqui said. “We have also been able to reduce our data centre footprint and administrative efforts by running our core banking database on Oracle’s flagship engineered system.”

Meezan has been expanding its network quite aggressively and its chief claims it is the fastest growing bank in the country – the bank has increased its financing portfolio by an impressive 50% this year. The Bank actively pursued growth in financings in all segments especially in SME or Commercial and Consumer Financing (primarily Car Ijarah and Easy Home) that grew by 62% and 66% respectively over the last year.

Giving further details, Siddiqui said the reduction in the bank’s ratio of non-performing financings to total financing (NPL ratio) was another achievement. Its NPL ratio now stands at 2.14%, down from 3.27% in 2015 as a result of major recoveries made during 2016. This NPL ratio is among the lowest in Pakistan’s banking industry whose average NPL ratio is 11%, Siddiqui said.

Meezan Bank maintains a very comfortable level of provisions against its non-performing financings with a coverage ratio of 118%. The focus is to build high-quality and well-diversified portfolio targeting top-tier corporate, commercial and retail clients, he said.

Islamic banking Industry deposits account for almost 13% of the total banking industry deposits. Meezan Bank’s market share amongst the full-fledged dedicated Islamic Banks operating in Pakistan is approximately 56%. Meezan’s market share for the Islamic Banking industry as a whole including Islamic Banking windows of conventional banks in Pakistan is 34%, making it the largest player in Islamic Banking.

 Stunning growth in deposits, fee income help Sindh Bank outshine peers

Since Sindh Bank is not a listed entity, it is hard to find analyst comments on its performance, but Umair Naseer, one of our research partners for this report, believes a strong growth in its deposit base and fee income over the last three years helped it shine in the small banks category.

Sindh Bank posted deposit growth of 42% in 2016, significantly higher than the industry average. This sharp uptick in deposit growth helped Sindh bank post flat Net Interest Income (NII) on YoY basis despite pressure on Net Interest Margins. The bank posted profit growth of 13% in 2016, which was driven by lower provision expense, down 36% YoY.

“The thing that makes Sindh Bank stand out in small bank is the exceptional growth it has seen in the last few years,” Naseer says. Deposits of the bank have grown by a three-year CAGR of 38%, which is well above the industry average within the small banks category. “This has helped Sindh bank rapidly increase its book size and profitability,” he adds.

The Topline analyst further says with growing deposits and branch network, the bank has also witnessed one of the highest fee incomes growth within the small banks, which clocked into the tune of 30% (aprox.) in the last three years. Amongst the small banks, it also has one of the lowest loss ratios (2.8% as in 2016) after Dubai Islami. Furthermore, the bank’s capital adequacy ratio of 18% is well above the target of 11%, making it less prone to risks, Naseer says.

Rise of digital: Telcos and FinTech companies gaining ground into banking

While Pakistan continues to operate with the traditional legacy banking, bankers all over the world are increasingly moving away from the brick and mortar model. In fact, they see the rise of FinTech companies as a big threat to their business.

According to the Global FinTech Report 2017 by PricewaterhouseCoopers (PwC), about 80% of financial services and FinTech executives surveyed for the study believe “business is at risk”.

“Many fear losing business to innovators, starting with payments, fund transfer and personal finance sectors,” the study says. The vast majority (88%) of participants indicated that they are worried that part of their business is at risk to standalone FinTech companies, it adds. “This business at risk is due to developments in FinTech and has grown to an estimated 24% of revenues.”

Explaining the threat, the PwC study says cutting-edge FinTech companies and financial innovation are changing the competitive landscape, and are redrawing the lines of the Financial Services industry.

“Innovation is coming from outside financial services and being driven by a variety of sources including tech companies, e-retailers, and social media platforms,” it says adding this approach certainly has been prevalent in some Asian markets.

The study says ICT and large tech companies are seen as potentially large disruptors to the banking sector as they are able to innovate at a far faster pace than incumbents — no wonder, funding of FinTech startups has increased at a compound annual growth rate of 41% over the last four years, with over $40 billion in cumulative investment.

As we type this report, Pakistan’s top bankers are holding seminars on digital banking, mobile commerce and FinTech to discuss challenges and form strategies to adapt to this change.

“Fintech is going to continue to grow beyond payments, it’s going to be credit, it’s going to be savings is going to be much more,” says Nadeem Hussain, who is considered to be a pioneer of FinTech in Pakistan.

There are currently 23 FinTech companies in Pakistan, out of which seven belong to Planet N Group of Companies, which is 90%-owned by Hussain, who has, perhaps, the most bullish take in FinTech. His holding company is in the process of launching another FinTech company.

“We’re looking over time to provide financial services based on data in your phone,” Hussain said adding the new company is structuring a deal to offer nano credit, nano savings, nano insurance and then nano private pension based on data on your phone.

Hussain further said there will be smartphone information-based solutions coming up and commercial banks will have to create their own solutions or absorb those coming from outside banking. Commercial banks will have to open up the core systems to FinTech because the customers will demand it, he says, adding it will be a customer-driven demand, not a fintech driven demand.

Hussain believes commercial banks will have to open up to FinTech, but it may not be swift as is the understanding of some other top bankers.

“Banks will not move immediately to digital because of the legacy banking mindset. They have been associated with this comfort zone for long and find it difficult to transition quickly,” Bank Alfalah Limited’s CEO Atif Bajwa said during a panel discussion at Digital Banking and Mobile Payments Summit 2017.

Talking about challenges and reluctance to invest in FinTech at the board level, the banker said this is a phase, which is still evolving and nobody knows what’s the exact model of digital banking.

“If you make a major investment today and fail to make money, we don’t know how the board would review it.”

According to Bajwa, Pakistan needs people in C-Suite who understand Fintech. However, if one goes by global stats, the picture is not very rosy.

“Only 3% of CEOs of leading banks have professional technology experience,” says Chris Skinner, who is a Fintech Titan and one of the Wall Street Journal’s Top 40 Fintech Influencers Globally — he was the main speaker at the Digital Banking and Mobile Payments Summit 2017.

Sharing the same number for Board of Directors of these leading banks, Skinner said only 6% of BoD members have professional technology experience while and only 40% banks have adapted professional technology.

“This is a fundamental weakness and we are missing out on huge opportunity,” Skinner said. The main problem is some consumers think these Fintech startups are not banks, they are banks’ clients — when it comes to banks, the mindset doesn’t seem to be any different.

“Banks are poor at putting themselves in customers’ shoes. They see mobile wallets as money transfer service, and not as bank accounts,” says Sima Kamil, Deputy CEO of United Bank. “We have to start working on it and develop an ecosystem for what you can buy from a mobile wallet.”

Kamil further said, “Youth is where we have to focus. They want to move away from cash and we have to give simple ways of doing it, that is what everyone is giving them in the world.”

Besides Fintech, telecom operators have also increasingly focussed on financial services. Almost every company has its own mobile financial services arm, offering some of the personal banking services to customers.

The SBP is targeting 50 million mobile wallet accounts by 2020, with major mobile MFS players like EasyPaisa and JazzCash pushing for a slice of the pie.These mobile MFS players are luring eCommerce users, the market catered to by conventional banks, by offering them discounts on online shopping. The recent Black Friday Sale by Daraz.pk  is a case in point.

JazzCash teamed up with Yayvo.com while EasyPaisa has been partnering with Daraz.pk for the last two years — the latter managed Rs1 billion in the sale on a single day  (Black Friday) with 35% of the total orders being prepaid transactions with Easypaisa mobile account last year.

As  Kamil pointed out banks see these MFS players as payment services, but they are not going to stop here.

“Mobile phones have become a remote control of our lifestyle, which opens up a window of opportunity,” Irfan Wahab, CEO Telenor said. Explaining, he said with a reach of 140 million customers, the reach of Telcos is far superior to banking. For example, he said more than 80% of the population is deprived of banking while more than 70% have access to mobile SIMs.

All telcos need to leverage their large customer base by offering banking services. In fact, as we write this report, the SBP has already announced it is coming up with a new set of regulations for digital banks, a clear indication of where the regulator is going.

The way forward

Fatani of Intermarket expects similar trends to continue in 2017. “This year will be similar to 2016 because profitability will remain under pressure,” he said adding, “I don’t see interest rate changing (increasing) this year.”

Basir, too, thinks 2017 will be a little bit tough for the banks and expects 8% growth in banks’ earnings in the current year. The banks’ income is shrinking but their cost is also decreasing, he said. For example, their deposit expense is falling because of low-interest rates. Banks are streamlining their admin expenses as well. Going forward, he said CPEC will also result in higher advances for banks.

“2017 is likely to be worse than 2016 because a five-year PIB is maturing this year,” says Afzal of Insight Securities. This PIB is worth Rs500 billion or 10% of banks’ total advances, which will affect their earnings, he adds.

The analyst acknowledged that banks are on the growth track but added they are unlikely to hit their 2014-2015 peak anytime soon. “I think things will normalise in 2018, which will be better than current year as NIMs will improve by then.”

Most analysts, however, agree that business and economic outlook is positive and CPEC will also provide some boost to economic activity. Banks’ NPLs have fallen now and they have started lending to private sector, and credit offtake is improving, analysts say.

According to SBP, loans to the private sector increased to Rs360 billion in July-Feb period of FY2017, up from Rs277 billion of the corresponding period. Similarly, advances to businesses increased to Rs303 billion in the same period, up from Rs219 billion of the corresponding period.

Similarly, consumer financing has also increased to Rs47.3 billion in July-Feb FY2017 compared to Rs11.4 billion of the same period of last year — an indication that consumer demand is on the rise and people’s income level has increased and they are buying things on loan and have the confidence to pay back, say analysts.

Although banks are now shifting focus back on their core segment, advances to the private sector, businesses and personal finance, it may take much more than that to make big bucks.

“I have a sense that we will stay dependent on the government. Some of these banks have almost forgotten how to lend,” Tarin says. “It will take them a long time to build the capacity to lend to customers.”

Tarin says banking has a very small footprint in the economy, which is a basic problem that needs to be addressed.

“We have coverage of only 33% of GDP as far as total banking is concerned,” the banker said adding that the number will be even worse if one takes into account informal economy.

“The biggest challenge that the policy makers and banks have is to increase this footprint,” Tarin said. He further said that lending to SMEs is about 7% to 8%, to the consumer is also in the 7% to 8% range while credit to agriculture is about 5% to 6% so the bulk of our lending is corporate sector, which has to change. Then you need to expand geographically, he said referring to eight or nine cities which consume over 80% of all banking credit

Talking about future of banking, Tarin said the brick and mortar model will be gone in few years and the very essence of banking will be taken over by large companies, the likes of Google and Amazon because they have the customer base.

“All they have to do is to spin around that customer base with the financial products,” Tarin said.

Pakistan’s best banks: How we did it 

For Profit’s first-ever best-performing banks study, we have tried to keep it simple and based our rankings purely on the banks’ financial performance. We dropped specialised banks and microfinance banks this year. We also dropped banks that had not published their annual accounts at the time of data collection, which brought our list down to 25.

Then, we classified them into three categories based on the size of their balance sheets as on December 31, 2016, so that we could make an apple-to-apple comparison.

Banks with a balance sheet size of at least Rs1 trillion were classified as large banks; those with balance sheet size of more than Rs500 billion but less than Rs1 trillion were classified as mid-sized banks and banks with balance sheet size of less than Rs500 billion were classified as small banks.

Next, we collaborated with experts from Intermarket Securities, Topline Securities, Arif Habib Limited, Insight Securities, and CitiBank to help us identify parameters for ranking these banks. After some deliberation over the key performing indicators gathered from these research firms, we divided the banks’ financial performance into three broader parameters: Growth, Size and Strength and gave them weightage of 50%, 10%, and 40% respectively.

We split these broader parameters into sub-parameters to cover a wide spectrum of financial performance indicators. For the purpose of simplicity as advised by most experts, we gave equal weightage to each of these sub-parameters.

In ‘Growth’, we considered the growth in banks’ deposits, loans and advances, fee income, operating profit (profit before tax), and Current Account Savings Account (CASA) balances. Similarly, in Size, we considered total deposits, operating profit and total assets. And in ‘Strength’, we considered the following sub-parameters: quality of assets, productivity and efficiency, quality of earnings, and capital adequacy.

To offset the impact of any short-term gains or losses, we collaborated with Abdul Ghani Fatani, Investment Analyst at Intermarket Securities, and Umair Naseer, Senior Research Analyst at Topline Securities to provide us with three-year data (based on consolidated annual accounts) for each of these parameters.

         Abdul Ghani Fatani                                        Umair Naseer

For each bank, we assigned a ranking point to all sub-parameters with the lowest value depicting the best performance in the given parameter. We then added the score of each sub-parameter in the ‘Growth’ segment and multiplied the sum to the category’s weight to reach a final score for that segment. We applied the same method on ‘Size’ and ‘Strength’ segments and then added the totals of all three categories to reach a final score, which decided the winners – the lowest value depicted the best performance.