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SBP asks banks to diversify investments

KARACHI (July 25 2005): The State Bank of Pakistan (SBP) has asked all banks and financial institutions to diversify their investments as the stock market volatility holds special risk connotations for its participants.

According to a report posted on State Bank of Pakistan webiste, the bank said that an overly optimistic market sentiment can move the index up.

However, such speculative upward movement in the market is always prone to sudden fall. The same goes for the recent downtrend in the case of Karachi Stock Exchange (KSE).

The KSE-100 index performed exceptionally well till the first half of March 2005. The index rose steadily all through CY04 and crossed the major barriers until it reached the 10,000 level. However, the index experienced a sudden fall in the second half of March 2005 and since then has exhibited erratic movement, with frequent ups and downs.

A closer look at the KSE-100 index shows that there was a gain of 4086 points from the beginning of the CY05 till mid March 2005, and then came an erosion of 2918 points till mid-May 2005. This was due to the exceptionally high market volatility.

While the hike in the market was due to a few stocks, the decline in the market was broad based. Since the banking system in Pakistan is exposed to stock market volatility, through direct investment in shares and indirect exposure through badla financing, it is of special interest to the regulators to test the resilience of the banking system towards stock market volatility.

The stock market volatility suggests that chances for further decline remain plausible. Empirically, the maximum decline in the stock market index since December 2003 was 9 percent, based on monthly averages.

Further decline in the index value is possible; hence, it is imperative to quantify the actual risk exposure of the banks. As a test for the resistance of the banks against potential losses, the investment holding of the banks in equities has been discounted by 20 percent. As any market decline shall first erode the surplus of these banks, it is important to see the relative strength of the surplus to bear such losses.

Over the year, the surplus of the banks against the shares has fallen in absolute terms in direct proportion to the fall in the equity investment. The surplus position shows that four banks are already carrying deficit against the shares. Hence, their risk exposure is substantial. Local private banks are quite prone to equities' risk as their surplus may fall short of the expected fall in the investment value. Foreign banks have no surplus available against their equities' holding. However, their contained exposure in equities lends comfort.

Bank-wise, 22 banks carrying 37 percent market share in the banking system shall have their surplus converted into deficit, given a 20 percent fall in the market value of investment in shares. As the banking sector is dominated by five large banks, their equities investment, being 63 percent of overall equities investment of the banking sector, is largely determinant of the shock that the banking sector might undergo.

Four of these banks have sufficient surplus to provide support against the market movements, whereas one bank might suffer a hit on equity beyond the shock rate applied in the study.

When the decline in the value of investment in shares is calibrated in the capital adequacy of the banks, all banks with aftershock deficits experienced some fall in their respective capital adequacy ratios. It is important to mention here that before shock, the CAR of all banks, except one, is well above the benchmark. Hence, the resilience of the banking system is already strong against such shocks. There is, however, some adjustment in the number of banks falling in various capital adequacy brackets. One bank in the 10 to 20 percent bracket has now shifted to the lower bracket of 8 to 10 percent. Overall capital adequacy position of the banks is not strained, though.

The current stock market scenario suggests that the news from the corporate sector shall remain the dominating factor in determining the market direction in future. Moreover, the past record reflects strong relationship between liquidity flows and interest rates; hence, the banks should take into account the liquidity and the interest rate scenario, which could further test the stock market in future. Also, barely 25 to 30 stocks account for most of the trading volume. This makes investments in equities highly susceptible to any decline in the value of these stocks. However, the regulatory pressures continue to keep the risks in check. The recent stock market decline has led to the strengthening of regulations governing stock market trading by the regulators. In consideration of the tight liquidity situation, SBP removed the restriction on the banks' badla financing* imposed in February 2005.

The indirect exposure of the banks shall largely be taken care of by the replacement of COT with margin financing by August 2005, providing the banks a prudent and secure mode of trading in the stock market and strengthening their resilience towards the stock market volatility. What is required is that the banks should enter other markets and diversify their risk base in compliance to the exposure limits set by the regulatory authority.

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