The State Bank of Pakistan (SBP) has warned that credit risk remains a key component in the risk profile of the banking sector, despite banks’ recent preference to place bulk of their incremental funds in safer assets.

According to the SBP’s Financial Stability Review (FSR) of Pakistan, the credit risk-weighted assets (CRWA) grew by 2 percent, or Rs. 65 billion, during the first half (Jan-June) of current calendar year 2011 (CY11), and credit risk remains intractable despite banks’ growing investments in government papers, which are mainly called most safe investment in the banking industry.

However, a robust growth in the assets, on the back of investments in government papers, markedly outpaced the relatively slower growth in CRWA to total assets. The resulted ratio of CRWA to total assets further decreased by 295 basis points, dropping to 47.8 percent by the end of June,’11. At the same time, the SBP said, the falling CRWA to total assets over the last few years was not an indicator of lower credit risk; rather it simply suggested a strong flight to quality amid high non-performing loans (NPLs).

The report said that to prevent further increase in the NPLs, the banks tried to manage higher infections by tightening their credit standards, with significantly restricting their lending to riskier sectors, like SMEs and consumers. Besides liberally increasing their investments in government debt, banks’ credit portfolio appears to be adequately covered against anticipated losses, and during first half of CY11, provisions held by the banking system increased by 7.6 percent or Rs. 28 billion.

“This increase partly reflects growing infection that requires higher provisioning. Growth in provisions outpaced the rise in NPLs. Besides it, the results of the macro stress tests conducted on banks’ credit exposure of June, ’11 suggest that Pakistan’s banking sector remains resilient against major foreseeable shocks”, the report said. According to the report, the adverse economic outlook and structural deficiencies in the economy are taking their toll on the debt repayment capacity of the borrowers, and the deterioration in economic indicators, as measured by a faltering GDP growth rate, has led to a surge in NPLs. NPLs of the banking sector further inched up from 14.7 percent to 15.3 percent, or Rs 31.4 billion, in first half of CY11 compared with a rise of Rs. 27.8 billion in NPLs during corresponding period of CY10. Still, the fact that NPLs continue to build up underscores the intractable nature of heightened credit risk, the SBP said in the report.

NPLs continue to build up, with Public Sector Commercial Banks (PSCBs) and mid-sized Local Private Banks (LPBs) appearing more vulnerable to credit risk and recent floods followed by torrential rains are also likely to contribute to the existing pile of NPLs.

The report said that the increase in NPLs during the half year under review was quite widespread, with most of banks witnessing an upsurge in NPLs and only a handful of banks registering a marginal decline.

In particular, the LPBs sustained the most damage, as their NPLs were up by 7.6 percent or Rs. 26 billion to Rs 368 billion during first half o CY11. Breakup of NPLs in terms of various banking groups shows that both PSCBs and midsized LPBs had significantly higher infection ratios than industry averages.  Specifically, infection ratios of 21.5 percent and 25.6 percent of PSCBs & mid-sized LPBs respectively suggest increasing level of vulnerabilities of these banks against credit risk. Going forward, the report said, if the economic performance continues to be lacklustre, the infected portfolio of PSCBs is likely to surge further.

The higher infection ratios of mid-sized LPBs are reflective of their limited choice in attracting quality borrowers. Primarily, it is the larger banks that have better outreach and access to low-cost deposits, which allows them to attract more creditworthy though low return borrowers, the report said.