Today there is an issue of both the availability of adequate credit on a timely basis from the banking system and at a price that makes industrial operations viable. While the State Bank of Pakistan has been following what is essentially a tight monetary policy to tackle inflation, it has been gingerly lowering the discount rate in anticipation of a further narrowing of the current account deficit and a slowing down of inflation. It’s been doing so notwithstanding worries about inflation from the firming up of oil and commodity prices, inflationary expectations of economic actors in the domestic market and the sharp revisions in electricity and gas tariffs.

However, one common criticism of banks in Pakistan is that they charge high interest rates on their lending not simply because of the State Bank’s tight monetary policy, but because of their enormous spreads – the difference between the interest rate banks pay to depositors and the interest they charge on their loans from these depositor funds. The current spread is as wide as 7.5 per cent, a size not seen in more competitive economies. It is argued that such a spread not only reduces the effectiveness of monetary policy it also makes a mockery of it while setting back prospects of reviving industrial growth. This article attempts to explain why banking spreads are high and why changes in the SBP discount rate do not get fully passed onto borrowers.

Following the operational death of PICIC, IDBP and NDFC, and in the absence of robust bond and equity markets, the task of providing long-term credit for financing greenfield projects or major expansions of existing industrial capacities became, by default, that of the commercial banks. These institutions were neither equipped nor re-tooled for such a role. One of the expectations of the financial sector reforms was that under the new financial architecture credit would not only be allocated efficiently but also extended at interest rates priced on the basis of market competition. None of this really happened in the form and at the pace envisaged, although banks continued to play a dominant role in the financial system.

The experience to date is that commercial banks tend to prefer greater flexibility in managing their assets and liabilities. There has been an increase in liquidity from the growth in deposits in recent years (although deposit growth has lowered in the last two years or so). However, there has been a growing portfolio of non-performing loans, as a result of the slowing down of the economy, and the rapid widening of the fiscal deficit with the seemingly never ending appetite of government for debt (an increase in excess of Rs1 trillion in just 18 months) and for financing its huge commodity operations- in excess of Rs350 billion for the purchase, storage and trading of wheat, rice and now sugar. Such an environment has made banks risk averse. They favour lending to the sovereign and holding government securities instead of extending credit to the private sector. These developments are understandable since the economic situation is uncertain and due to the prediction that the economy will barely grow by 3 Per cent. Moreover, pressure was also brought to bear on banks by the government to lend to the power sector and to all the key players in the energy sector to help reduce the size of the circular debt problem. With government agencies accessing funds at lower rates of interest and crowding out the private sector from the credit market, industry has to brace itself to pay a higher cost for credit facilities.

For the interest rate market to react efficiently and quickly to changes in the SBP discount rate depends on the efficiency and effectiveness of the regulatory system, the extent of competition between the financial institutions and the range of financial instruments and products on offer. A recent Chicago University paper has argued that even in a developed financial market like the UK the interest rate response of the financial systems to changes in the central bank’s policy rate tends to be weaker than hope for. It is found that the reduction in the policy rate has not been fully passed onto the borrower despite the markets having financial depth.

In our case, the SBP’s Prudential Regulations, designed with the laudable objective of ensuring the strength, stability and smooth functioning of the financial system also tend to keep interest rates on lending high. Banks are required to preserve a cash reserve of 7 per cent of their liabilities/deposits and make investments in approved securities, largely government instruments, under the Statutory Liquidity Reserve Requirement (SLRR) that presently stands at 9 per cent of a bank’s liabilities. Then there is the State Bank’s requirement pertaining to the capital adequacy ratio that the banks are required to maintain, which gives a zero weightage to credit extended to even blue chip companies – in other words disincentivising lending to the private sector. Next are the Prudential Regulations covering recognition of income, quality of assets allowable as collateral, provisioning against poorly performing loans, overall and single borrower exposure, a bank’s willingness to take on risk and the risk premium that it would be looking for based on its assessment of the credit worthiness of the borrower influence lending decisions in terms of who to lend to and the State Bank regulation that savings account holders be given a minimum interest of 5 per cent per annum. All these factors tend to push up the cost of banking operations.

Finally, the legal and procedural constraints to the collection of debts in our economic and political environment and the difficulties of foreclosure in the case of defaults and the government’s borrowings over and above the Statutory Liquidity Reserve Requirement also keeps the interest rates high for the private sector.

In this writer’s view, however, despite fears of lack of adequate volumes of credit and the continuingly high cost of credit (in nominal, and not so in real, terms), the issues related to the availability and price of energy are more important for maintaining the competitiveness of the domestic manufacturing sector industry and for keeping the wheels of industry running.