Increasing Credit Risk: monetary tightening may dent borrowers repayment capacity

KARACHI: The monetary tightening stance of the State Bank of Pakistan (SBP) may dent repayment capacity of borrowers and may increase the credit risk.

The SBP admitted in its Financial Stability Review (FSR) 2018 released on Thursday. The central bank said that the banking outlook depends a lot on the future economic prospects and the corresponding policy responses.

“The monetary tightening towards the end of CY18 and first half of CY19 may lead to re-pricing of loans. This may improve the net interest income and, thus, profitability and solvency of the banking sector,” the SBP said, adding that on the other hand, it may dent the repayment capacity of the borrowers, thus, escalating the credit risk.

SBP raised the policy rate by 325 bps post CY18 (until July 2019) to address macroeconomic challenges.

The central bank said that though banks’ fresh loans are disbursed at a higher rate in response to monetary tightening, there still exists a significant portion of outstanding loans, which may be re-priced with some lag due to contractual bindings.

The fact that major rise in policy rate has occurred towards the end of CY18 and beyond, the borrowers may face further hike in interest expense later on. This coupled with the lower corporate profitability may deteriorate the repayment capacity of borrowers and increase Non-Performing Loans (NPLs).

“Generally, a lag of four to six quarters exists between the rise in interest rates and the subsequent buildup of NPLs.”

Further, considering the contraction in LSM during July-March FY19 reflecting the dwindling performance of non-financial corporate sector, suggest that the odds of defaults are increasing.

Further, any downgrade of a sizeable portion of NPLs parked under “doubtful” and “substandard” categories could raise the provisioning expense for the banks. “Thus, the credit risk remains paramount, going forward.”

Besides implications arising from the realization of credit risk, the profitability of the banking sector depends upon the costs associated with mitigating the emerging operational risks and the interest rate dynamics.

The mitigating measures against various risks such as compliance with AML/CFT related laws and regulations, fortifying systems against cyber-attacks, enhanced due diligence to ward-off fake/benami accounts, seeking legal remedies to manage challenges in overseas operations, etc. are all costly.

The banks investment behavior in government securities and the interest earned there against are largely dependent on interest rate dynamics. Moreover, fiscal measures (such as super tax) has implications for the bank’s after-tax returns and solvency.

In order to meet the growing financing demand of public and private sector, banks need to renew their focus on deposit mobilization. The sizeable rise in MSR may help in restoring the deposit growth, though.

Like CY18, the enhanced CAR requirement (from current 11.9 percent to 12.5 percent) by the end of CY19, given slowdown in profitability, may compel banks may have to focus on raising capital through issuance of Basel III qualifying instruments.

Banks, particularly small sized ones, will need to formulate concrete and time bound capital enhancement plans to meet their capital requirements.

The strong NSFR and LCR of banks suggest that they will remain compliant with the Basel III liquidity requirements.

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