The State Bank was left with no option but to come hard on the banks. Having failed to pay a decent return to depositors on their own, banks have now been forced to pay a minimum of 5 percent return on PLS saving deposits.

Let us look at the banks' data to find out why the banks failed to sufficiently remunerate the depositors on their own. Foreign banks have made a bee line to enter Pakistan's lucrative banking industry. The latest is the planned purchase of 15 percent stake in MCB by Maybank of Malaysia. The aggregate return on equity (ROE: return on owner's money in business) of the banking industry, for 2006, was 23.7 percent. This exceeds the return in other industries and is massive by any standard. No wonder that foreigners are interested. A couple of years back large commercial banks were reeling under the burden of a number of non performing loans (bad and doubtful debts) and the ROE for the industry was negative. The banking industry, without doubt has staged a massive turn around.

Some aggregate statistics of commercial banks (table 1) provide a partial answer for the turn around. The ROE of the banking industry has been on an upward course since 2002 (2002: 14.3%, 2006: 23.7%). It seems more than a coincidence that from around the same time the banking spread (difference weighted average return on loans and weighted average cost of deposits) has been on the rise (2003: 4.26%, 2006:7.44%) while non performing loans (NPLs: loans that are not paying interest and seem difficult to recover) have been on the decline (2001: 19.6%, 2006: 6.9%).

Noteworthy events, in the ongoing decade, that might have contributed to this trend include; (i) with the privatization of two large banks, United bank and Habib bank more than 80 percent of the banking industry went into private hands (MCB and ABL were privatized in 1990 and 1991), (ii) to take care of the chronic NPLs of all public sector financial institutions, the government created a Corporation for Restructuring of Sick Industrial Units (CRSIU). To clean balance sheets of the banks their NPLs were transferred to CRSIU and (iii) the tax rate for the banking industry was gradually reduced from 53 percent to 35 percent by December 2007. The three measures contributed to the increase in revenues of the commercial banks but the banking spread did not decline, rather the profitability (ROE) increased. What's the implication? No part of the increase in revenues, due to decrease in NPLs and decrease in tax expenditure was passed on to the bank customers (borrowers or depositors). The tax cuts and the creation of CRSIU? that took care of a major chunk of NPLs, show that the government contributed to the increase in profitability of the banks. Some pass-through of the higher revenues to the public at large was expected ? by way of decrease in banking spread (specially increase in return on deposits). Sadly this did not happen.

Banks' interest rate, in one way or the other, is supposedly linked to the policy rate of the central bank. The Treasury bill yield after registering an all time low of around 1.5 percent, in December 2003, resumed its upward path. With the increase in yield on treasury bills the lending and deposit rates of banks also began to register an increase. The increase in banking spread since 2003 implies that pass-through of the increase in T.bill yield has been more to lending rates and less to deposit rates. Incidentally around this period the banking as an industry had just begun to enjoy its current privatized status (with privatization of Habib bank). Cynics, who attempt to establish a relationship between higher spread and privatization, may not be entirely wrong. It is the bank customers who have paid the cost of turn around.

No one, accept perhaps the banks, dispute that the banking spread should decline. The scarcity of savings is considered an impediment to boosting investment rate and hence economic growth. Encouraging savings call for a handsome remuneration ? handsome return on deposits. The authorities have been seized of the issue. There have been statements in this regard from even the office of the President of Pakistan. Before going for the drastic step of fixing minimum deposit rates, SBP carried the view that banks being in the private sector are free to set their own deposit and lending rates and that the central bank can mainly use 'moral suasion' to induce the banks to raise the return to depositors. The bread sellers and the milk sellers are also in the private sector and prima facie the structure of their markets is more competitive than the banking industry but still the government keeps a strict watch over prices and is more often able to keep prices in check with fair degree of success. Why the government does this in a market economy? Because the commodities in question being necessities, the demand for these is not too responsive to price changes.

Market forces determine fair price in a competitive environment when new players are free to enter the market. Entry to Pakistan's banking industry is restricted, first by the decision of the SBP not to issue more banking licenses and secondly the minimum capital requirement of Rs. 6.0 billion, itself serves as a constraint on the entry of new banks in the industry. Being signatory to Basel accord II, one cannot do much about the minimum capital requirement, but still it is only fair to expect that with current level of profitability many players would have liked to enter the lucrative industry. Had this been otherwise the ban on issuance of new banking licenses would have been meaningless. The competition being restricted, by the will of authorities, one cannot expect the market forces to deliver a fair return on deposits, on its own. Here comes the regulator. With top 5 banks holding 50 percent of the deposits and top 10 banks holding onto 73 percent of the industry deposits the industry can certainly be, termed, oligopolistic, necessitating a more active role for the regulator. It is this active role that now the banks have almost forced upon the central bank.

Before going for the drastic step the central bank tried other measures. Of late the SBP has made mobilization of long term deposits more attractive for banks. Now banks are not required to hold cash reserve ratio (minimum cash balance with SBP that earns no return) against fixed deposits of over one year. SBP hoped that the measure will raise the spread by increasing the share of high yield fixed deposits in total deposits. The composition of commercial banks' deposits, as of December 2007, (table 2), presents a revealing picture.

The depositors with out doubt favour immediately encashable deposits (table 2) even if these yield less or even nothing. Ninety five percent of the deposit holders, who hold 70 percent of the deposits (table 2) do not seem to care about interest income. The depositors seem insensitive to interest rate change, especially if it is small. In this scenario making mobilization of long term deposits more attractive cannot work. A change in composition of deposits cannot be achieved by offering a 0.5 percent or 1 percent additional return to depositors who are insensitive to interest rate changes ? the depositors will not be willing to give away the facility of immediate encashment for a meager increase in income. To address the issue of banking spread, we need to take into account the behavior of depositors, whose encashment considerations seem to dominate the return lure.

Aggregate bank advances were 67 percent bank deposits as on December 2006. The volume of fixed deposits being only 30 percent of the total deposits, savings deposits are also extended as loans. The weighted average return on Bank's outstanding loans is 11 percent. The question arises, why the banks cannot pay a decent return on savings deposits, which are funding bank loans? The advances to deposit ratio at 67 also implies that balance 33 percent of deposits are invested in liquid assets (assuming that the deposits are invested only in loans and liquid assets). With the cash reserve ratio (CRR) standing at 5 percent (that earns no return) the balance 28 percent is invested in earning liquid assets, most of which could be in highly liquid, risk-free treasury bills. The return on liquid assets of the 10 large banks in 2006 was by and large, in the range of 5 percent. Again the question arises, if banks are earning on liquid assets why they cannot pay some return on current deposits which are funding the liquid assets.

Given depositors' preference for deposits encashable at no or short notice, the banks need to introduce deposit products that pay return on such deposits. The banks don't have to be very innovative for the purpose. Products like Money Market Deposit Accounts (MMDAs) and Notice on Withdrawal (NOW) and Super NOW are already available in developed countries that ensure some return to depositor, depositing for a short term. Interestingly, to hedge against inflation, the banks in Pakistan are increasingly linking their lending rates with KIBOR. Why the banks cannot link deposit rates with some reference rate like KIBOR or Treasury bill rate etc.?

Banks have used their market power or have rather exploited for years the depositors' preference for short term deposits, to pay a negligible return to depositors. This has forced the central bank to come hard on the banks. The case only proves the established; greater the market power of an industry the more the role of a regulator.

Banking Industry: Some statistics

Year 1999 2000 2001 2002 2003 2004 2005 2006

ROE -6.2 -0.3 -0.3 14.3 20.3 19.6 25.1 23.7

Banking Spread 8.22 8.64 8.62 6.71 4.26 5.39 7.26 7.44

NPLs 22 19.5 19.6 17.7 13.7 9 6.7 6.9

Composition of Bank Deposits

% of Total % of account

Deosits holders

Current 25.1 31.4

Savings 43.2 62.6

Other 2.1 1.2

70.4 95.2

Fixed:

Upto 1 yr. 18.3 1.4

Above 1 yr 11.3 3.4