Pakistani banks don't lend to private sector

There are good reasons why the banks in Pakistan have seen superior risk-adjusted returns on government bonds compared to private sector lending, some of which has been covered by Profit in previous editions. This story, however, is not about why they find government lending attractive, but rather why they find private sector lending unattractive.

First, some context: since the second quarter of 2011, the government of Pakistan has accounted for a majority of the lending by banks in Pakistan, almost without interruption, according to aggregate banking sector data from the State Bank of Pakistan (SBP). It has also accounted for the majority of net new lending for that time as well.

And even when the banks do lend to the private sector, it tends to not end very well for the banks. The country's infection ratio, or the gross non-performing loans to gross total loans, is not exactly great either. That figure stood at 9.7% in the first half of calendar year 2020, compared to 8.8% in 2019. Still, at least this is somewhat manageable: to recall, that ratio reached an alltime high of 16.7 % in September 2011, and a record low of 7.1% in June 2007.

The current amount of gross non-performing loans for banks in the country, as of December 2020, comes in at a staggering Rs829 billion, according to State Bank data.

Let us place that number in context: In developed economies like the United States and Britain, this ratio is typically around 1% of total loans outstanding, or sometimes even less. In the United States, for instance, when the

NPL ratio went from 1% in 2007 to 5% in 2009, it caused the greatest financial crisis the country had ever seen in almost a full century. Even in India, the worst the ratio had ever gone before the pandemic was 11%. In Indonesia, the ratio often hovers around just 3%.

In other words, Pakistan is unusually bad at private sector defaults, even by emerging markets standards. How did we get here? It is a question that banks are asking themselves as well.

At least part of the reason appears to be legal: both the law as it is currently written, as well as judicial precedents and practices as established by the courts. As behavioural economists are fond of noting, the more you incentivise something, the more of it you will get. And in Pakistan, the law, it seems, incentivises taking a loan from a bank and not paying it back.

Yes, we are talking about the standard problems of the Pakistani court systems, where when banks take legal recourse, typically against large companies who have defaulted, they find that their case is stuck in courts for years - sometimes even decades. But as we will note in this story, that is far from being the only problem (though it is, admittedly, one of the biggest ones).

And that is why Profit finds itself in the unusual seat of, for once, agreeing with the banks. Around the world, this very ability of banks to immediately receive their money, or for one's assets to be captured by the bank, creates a system of checks and balances, and also, for banks to not exactly be viewed favourably. But in Pakistan, the lack of an efficient, or even ruthless judicial system, means banks are simply institutions one can take money from, while court cases are pending.

It does not help that there are several companies in Pakistan who are perfectly comfortable evading accountability when it comes to their loan defaults. Why is this happening? Profit takes a look at some of the reasons behind this quagmire, and the very real ramifications it can have. When it comes to designing effective banking laws to prevent the rise of non-performing loans one has to consider this main point: how does a society enforce a loan contract against a borrower who has defaulted on their loan payment obligations, and what is the most effective way to go about it?

In designing such a law, there are two sets of interests that need to be considered: those of the borrower, and those of the lender. Make matters too easy for the lender, and you open up the possibility of the lender engaging in highly exploitative behaviour with the borrower.