The latest financial soundness indicators released by the SBP have given out mixed signals on the performance of the local banking industry. The positives first: The banking industrys profitability is on the mend due to a variety of reasons. Higher interest rates, decent deposits growth (29 percent in 18 months), availability of high rewarding sovereign investments enabling banks to sustain high level of margins and cost cutting measures both at administrative level and pouring low cost demand deposits; all helped the banks attain improved bottom lines. The commercial banks ROE jumped significantly to 14.2 percent in 1HCY11 from 10.7 percent at the end of same period a year ago. This represents a significant improvement compared to CY09 and CY08, when the commercial banks ROE averaged around 7.95 percent. The capital position of the commercials banks also remained strong, as bankers managed to keep risk weighted CAR unchanged at 14.2 percent at the end of June 2011 over same period a year earlier. Simultaneously, Tier 1 Capital to RWA also stayed constant at 12.2 percent. A higher CAR means higher protection level for depositors. But the critics relate higher capital adequacy ratios to the banks growing interest in sovereign instruments which have a zero risk weighting. This is also clear from a declining capital to total assets ratio, which eased down to 9.4 at the end of June, 2011, down from 10.1 percent same period last year. Considering the fiscal quagmire and the ever rising debt level, there shall be a healthy debate on assigning some risk weight to government borrowing or putting a cap on a banks exposure to treasury bills. However, asset quality indicators painted a dismal picture as a combination of high interest rate environment and weak economy led to poor asset quality. The commercial banks infection ratio stood at 14.8 percent at the end of June, up from 12.5 percent same periods last year. On top of that, a worrisome development is that the ratio of toxic loans grew in the face of negligible growth in advances. The gross advances level on the commercial banks balance sheet rose by merely seven percent in the past one and a half year. The current higher infection ratio has bucked the market expectation, which had earlier forecasted the ratio of bad loans to have peaked out in 2009. Foreign banks remained more prudent, with the infection ratio of nine percent as of June 30; nearly 5.8 percentage points lower than the average of commercial banks. In part, the deterioration in the asset quality in the past one and a half year will have an adverse bearing on the industrys bottom-line down the line since it will result in higher provisioning cost. The mix of positive and negative indicators calls into question, the soundness of the local banking industry. To no ones surprise, the analysts warn the market of the industrys higher profitability level. The banking industrys profitability is concentrated in the hands of big five banks and has not been supported by growth in advances level or steady asset quality. This can be gauged from the fact that the commercial banks ADR fell to 55.3 percent at the end of 1HCY11, a drop of six percentage points in the past one year. This highlights the existences of conflict of interest between mangers and shareholders in the industry, as the former focuses on short term profitability, while the latter demands quality of earning assets.