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Changing dynamics of commercial banking

As the State Bank of Pakistan (SBP) is scheduled to announce Monetary Policy on Saturday, this week, it is anticipated that the central bank is obliged under the external pressure of multilateral donors to increase the policy rate by 25bps. It is also anticipated at each future announcement; rate will be increase to take it to 10% before 31st December 2018. The SBP raised the policy rate by 50 basis points to 6.5 percent in the last monetary policy announced in May. The central bank pushed up its policy rate by a cumulative 75 basis points since January 2018.

While the economic analysts fail to comprehend the logic behind interest rate hike, the sale objective seems to be increasing profit of commercial banks. It is a reward for their much criticized policy of putting most of the eggs in one basket, investing in government securities to support the Government of Pakistan to overcome its budget deficit.

Topline Securities has revised its interest rate forecast for calendar year 2018 and 2019 by 50bps each to 8.5% and 9.25% respectively from the current level of 6.5%. State Bank of Pakistan (SBP) in 2018 so far raised policy rate by 75bps to 6.5%. The brokerage house is of the opinion that banks having high current account to total deposits ratio and short term investment maturity profile will be the key beneficiaries.

This anticipation of rate hike bodes well for banking sector’s profitability that comprises of Interest on earning assets including Advances, Investments and other Lending, rises following rate hike. On the expense side, cost of remunerative deposits (which forms 66% of total deposits) and borrowings goes up.

It is to be noted that banks do not incur any cost on current accounts, therefore higher the current account the better it is for banks in rising interest rate scenario. On the asset side, the shorter the term of investments, the better it is for banks in rising interest rate scenario as they gets reprised more quickly.

Treasury-Bills (T-Bills) are short term in nature with maturity period of up to one year whereas Pakistan Investment Bonds (PIBs) are of longer duration instruments with maturity over and above one-year.

The brokerage house has revised interest rate forecast for calendar year 2018 and 2019. The revision in interest rate forecast is based on the premise that sharp deterioration in external account (expected Current Account Deficit of US$18 billion for FY18) and likely IMF program in 2018 would entail aggressive monetary tightening in upcoming monetary policies.

CPI inflation is also expected to average around 7% during 2018-20 on the back of depreciating PKR and rising oil prices. In June 2018, CPI inflation was recorded at 5.2%, taking FY18 inflation averaged 4%. In the last 2-years, SBP has maintained positive real interest rates of 1.8%. It is to be noted that SBP had also adopted a similar tightening approach in 2008 when interest rates were raised sharply by a cumulative 5% when Current Account Deficit (CAD) climbed to US$10 billion (8% of GDP) inflation peaked at 25%.


Sharp rise in interest rates are generally associated with pickup in loss ratio, as cost of borrowings increases. The brokerage house believes that the impact of the same will not be significant enough to nullify the impact of increased Net Interest Income from policy rate rise.

An analysis of last 18 years of Pakistan’s banking sector suggests that interest rates and loss ratio have a positive correlation of 0.3%, which means that on every 1% rise in interest rates, NPL ratio rises by only 0.3%, which is not significant enough to negatively impact profitability. Net advances of the sector as of March 2018 were reported at Rs6 trillion.

Banking industry was severely affected during 2008-09 economic turmoil as NPL ratio of the sector shot up from 8% in 2007 to 9% in 2008 and to 12% in 2009. During the said period, not only there was sudden rise in rates (discount rate raised by 5% to 15% in 2008) but overall macroeconomic growth slowed down sharply to 0.9% in FY09 from 5% in FY08) amid rising oil prices, impact of global financial crisis & spiraling inflation. Furthermore, consumer financing contributed around 8% of the total financing in 2009 which has now fallen to 4% of financing as per SBP, minimizing any chances of sharp hike in NPLs.

In contrast to 2008, NPL ratio is expected to marginally increase from 8% in 2018 to 9.5% in 2020 given 1) GDP growth rate is expected to average 5% in FY19 & FY20, 2) lower exposure to consumer financing, 3) higher consumer confidence and 4) improved financial health of banks.

It is believed that banks with high exposure in consumer financing including Silk Bank (SILK), BankIslami (BIPL) and Standard Chartered Bank (SCBPL) may be more affected from sharp rise in interest rates, due to the increase in NPLs.

Banking Index (BKTI) in year to date is down 1.7% versus KSE-100 index which is down 0.5%. This underperformance was mainly due to few of the negative developments like pension case, continuation of super tax, tightening of regulation in regards with BASEL-III implementation and bank specific issues relating to UBL and HBL.

The brokerage house believes that the negatives have been priced in as most of the banking scrips are trades at attractive prices, offering ROE of 16% as compared to average ROE of 15% during last 5-years. Banks also offers attractive dividend yield of 7%. In 2018, sector earnings may remain flat amid maturity of high yielding PIBs and one-off pension cost. However, from 2019 onward banks are expected to witness strong earnings growth owing to expected rise in interest rates and strong balance sheet growth.

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