In the end, the State Bank of Pakistan (SBP) decided to be magnanimous to the banks, cutting its benchmark interest rate by a ‘meagre’ half a percentage point to 9%. Many bankers will no doubt have breathed a sigh of relief. The reality, however, is that their troubles have only just begun.
The irony is that the banks’ biggest weakness right now is something that they have implicitly thought of as their biggest strength: their absolute dominance of the country’s financial system. The funny thing about irony, however, is that it has a habit of being cruel. And the banks have been caught at the wrong end of a very cruel joke indeed.
The banks used to think they were effectively an oligopolistic cartel providing a service to depositors on poor terms. This allowed them to earn the highest net interest margins (the difference between what they pay out to depositors and what they charge borrowers) in the region, and among the highest in the world. The banks were not wrong. They really could afford to give a horribly bad deal to Pakistani depositors because, come on, where else can you put your money?
All was well, so long as they had a legally-tolerated oligopoly on the deposit-taking side. Even though the market was freer on the lending side, particularly for high-quality corporate borrowers, that deposit-side oligopoly kept the banks’ margins very comfortable. The Pakistani depositors were effectively being scammed, but who cared about them? The banks were happy. All was well. All could have stayed well. But, of course, it did not.
You see, making comfortable margins on their regular business was not enough for the banks, since it still involved having to do actual work. The easy profits, however, made the banks lazy. So when the federal government started borrowing insatiably from the banking system to finance its budget deficit, the banks were more than happy to lend. Who would not want to take in savings accounts at (what was then) 5%, and lend to the government at rates that at one point reached 15%? It was practically free money, with the added bonus of not having to set any capital aside against lending to the government.
But, as always in financial crises, the banks overdid their irrational exuberance for government debt. They have effectively turned the government into a monopoly borrower, which now accounts for more than half of all of their lending. And they had unfortunate timing: just as the relatively free market on the lending side of their balance sheet turned into a monopoly against them, the State Bank started to care (not much, but just a little bit) about depositors, raising the minimum interest rate on savings accounts.
Here is where things stand now: the banks have tried to reconstruct their oligopoly on the lending side to try to get higher rates from the government, but they face one problem: in any battle of market power between an oligopoly and a monopoly, the monopoly is always going to win.
And now the banks are stuck. They have lent so much to the government that they have crowded out the private sector almost completely, causing it to atrophy, along with their own corporate, commercial and retail lending workforce. This, paradoxically, means that they are even less tempted to lend to the private sector, and thus lend still more money to the government. The banks are trapped in a vicious cycle and do not have a way out.
The State Bank is trying to play the role of the referee, effectively by trying to shock the banks out of their reliance on government borrowing. It has raised deposit rates to increase their cost of funds, and continuously lowered lending rates to make the banks more desperate for higher rates from private sector lending. It also keeps pointing out that private sector lending is less risky when interest rates are low.
The SBP is also not lowering rates as low as it could (theoretically, lowering rates to 8% would be justifiable) because it knows that inflation will not stay as manageable as it has over the past year, and it does not want to increase the interest rate risk for companies looking to borrow money.
The central bank has done all it can to make this as easy for the banks as possible. Now it is up to them to try to dig themselves out of this hole.