KARACHI: A cut in interest rate of four per cent over the last 15 months has squeezed profits for the banks and a declining interest rate scenario has exposed them to a reinvestment risk as they continue to invest in government papers.

The honeymoon period for the banks seems to be over as banking spreads, a key determinant for Pakistani banks’ core earnings, for the first 10 months of 2012 stood at an average of 7.11 per cent; the lowest 10 monthly average in seven years.

This is down 54 basis points compared to 7.65 per cent during the corresponding period last year.

In a rising interest rate scenario, the banks earned huge profits as most of their investment went into government papers and while that minimised the risk factor, it completely crowded out the private sector which was already suffering from low economic growth.

However, as inflation started to decline, the central bank opted to loosen its monetary policy and slashed its key policy rate to 10 per cent in October, with another cut expected this month.

“We are actually facing two problems: the falling interest rate on government papers will cut the profits of the banks, and, secondly, how to use our money if we don’t invest in government papers,” said a senior banker.

Lending to the private sector is a bigger risk for the banks as it has been in trouble for the past few years which is reflected by the huge default of Rs650 billion. In fact, the default increased despite curtailed lending to the private sector. Banks also feel that the private sector itself is not ready to invest in new ventures due to the current energy crisis and poor law and order situation.

Investing purely in government papers has been discouraged by the central bank and analysts. In its latest report, ‘Financial Stability Review’, the State Bank said rising investments with restrained credit disbursements re-shaped the banking asset portfolio as reflected in the decline in advances-to-deposits ratio (ADR) from 56.7 per cent in the first half of the CY-11 to 54 per cent by the second half of CY-11. This situation requires diligent monitoring since continuous decline in ADR indicates undesirable results for private sector credit.

“Continuing investments in government securities can expose banks to reinvestment risks in a declining interest rate scenario,” said the State Bank report. Banks are eagerly waiting for a reduction in the floor rate of six per cent set on PLS savings deposits, which was implemented in this fiscal. A reduction in the discount rate by 200 basis points during FY13 has already squeezed spreads, so this will be high on their wish list.

The State Bank recently abolished the minimum savings deposit held by Islamic banks. “The SBP has already put a minimum deposit rate to penalize banks. Spreads in October declined due to this reason. Any other move to force them to lend to the private sector would be against the free market theory. Economic growth along with low interest rate will automatically force the banks to lend to the private sector,” said Mohammad Sohail, of Topline Securities.

The central bank recently identified another problem for the banks, saying the situation was challenging as given the uncertain macroeconomic and political outlook of the country, it was getting tougher for these banks to attract funds to further enhance their capital base.