COMMERCIAL banks play a key role in the mobilisation of financial savings and the financing of economic activity through financial intermediation between savers and borrowers.
Unlike other businesses, commercial banks hold other people’s money and their operations have a direct bearing on the rate of return and safety and liquidity of funds placed at their disposal as deposits by the general
public.
public.
The State Bank of Pakistan (SBP) was created, inter alia, to establish a regulatory and supervisory framework to ensure soundness of the banking practices, to provide protection to depositors’ interests and to regulate the banks’ lending business
in line with national economic priorities.
in line with national economic priorities.
To enable it to undertake these regulatory functions, the SBP was given wide powers in the SBP Act, the Banking Companies Ordinance and some other legislation.
In fulfilling its regulatory responsibilities, the SBP can frame rules and regulations to ensure good corporate governance and enforce the prudential regulations through onsite and offsite supervision. One of the responsibilities of the SBP is to make sure that banks do not exploit the depositors or the borrowers and earn profit on their equity through legitimate business practices.
The difference between a bank’s average rate of return on deposits and the average rate of interest on lending is called ‘interest rate spread’. The rate spread not only determines the profitability of banks but also indicates the efficiency, competitiveness and soundness of the banking system. The normal rate spread is three to five per cent in most of the countries where banking business is run on an efficient basis.
During the last decade, the rate spread has gone up substantially making banking one of the most profitable businesses in Pakistan. According to the SBP publications, the spread between the weighted average deposit and lending rates of all banks has increased from 4.63 per cent in June, 2003 to 8.90 per cent in July, 2011.
The combined profits before tax of all the banks rose from Rs4.5bn in 2000 to Rs80.7bn in 2009. Profits after tax changed from a loss of Rs2.8bn to a gain of Rs54.4bn during the same period.
The abnormal rise in the rate spread and profitability of banks means that the depositors or the borrowers or both have been at the losing end, and so has the economy.
The high spread is an indicator of lack of competition in the banking system, or a systematic collision among the banks and a failure of the regulatory authorities to discharge their statutory responsibilities. Privatisation of banks had necessitated a stronger and not a weaker or timid central bank. Similarly, a free-enterprise system requires a stronger and not a weaker regulatory framework.
The large interest spread has implications for saving, investment, income distribution, rate of economic growth and the conduct of monetary policy in addition to its adverse effects on individual savers and borrowers.
The country has recorded a rate of inflation of over 15 per cent per year for the last several years. A rate of return on savings lower than the rate of inflation implies a negative real rate of return on savings.
For example, if the banks give an average return of five per cent on deposits in the context of an inflation rate of 15 per cent, the savers will annually lose 10 per cent of the purchasing power of their savings held in banks. Whatever amount people can save they will be better off in keeping it in real assets, or even not saving it at all, rather than to keep it in banks.
However, given the need to save for rainy days, the liquidity preference of people and lack of opportunities to hold their saving in other instruments, most of them end up in keeping their savings in bank accounts even at a negative real rate of return.
Moreover, taking advantage of the Sharia’s prohibition of fixed return on savings, banks encourage small savers to keep their saving either in interest-free accounts or in profit and loss accounts whose return is not predetermined At the end of the period, banks arbitrarily decide a rate of return on such deposits at their discretion. On the other hand, banks do not follow the Sharia injunction on the asset side and mostly use the deposits in lending them on fixed rates of interest to borrowers.
The cover of Sharia injunctions and the free-enterprise system is used by banks for the exploitation of small savers, and the SBP is letting it happen. In such a situation, it is no wonder that Pakistan’s rate of saving has been declining and is one of the lowest among the countries of the region.
Another effect of these banking practices is that the banking system has become an instrument of transfer of resources from the small savers to the rich borrowers, including some wilful defaulters. Lower saving rate, inequitable distribution of income, wilful loan defaults and inefficiency of investment in turn retard the rate of economic growth.
Equally importantly, the wide rate spread stands in the way of implementation of a pro-growth and effective monetary policy.
Monetary policy signals are usually transmitted to the market through changes in interest rates by the central bank.
If banks sit on a large cushion of a wide rate spread, the signals coming out of the SBP for change of direction in the monetary policy can easily be blunted by partial use of this cushion by the banks.
The SBP needs to review the existing rate spread with a view to taking measures to bring it down to a normal range. If the corridors of power in the SBP are reluctant to move believing that the SBP has no such power, they are well advised to dust off the past record of the SBP and re-read the banking laws more carefully.
The writer is a former governor of the State Bank of Pakistan.
