WITH almost all banks having come out with their third-quarter results, a debate has yet again begun if they will be able to sustain their big profits next year.

Such debates had erupted in late 2014 and early 2015 as well. The central bank had embarked upon a monetary easing cycle in November 2014, and since then (till last Thursday), the benchmark interest rate has been reduced by a whopping 400 basis points to 6pc from 10pc.

Such a big drop in the policy rate in a relatively short period of time had sector watchers wondering if the banks can continue on their merry money-making spree. It also didn’t help when the central bank tweaked its interest rate corridor in May, which led to a systematic (albeit slight) reduction in banks’ margins.

However, the banks’ profits kept on rising. The post-tax earnings during the first nine months of the year (9MCY15) of the 10 largest, listed conventional banks clocked in at around Rs119.4bn — up almost 19pc from the same period last year. The average rise in profitability for each bank worked out at 26.2pc.

There are two major explanations for the seemingly immunity of banks’ profits to declining interest rates. First, over the past couple of years, banks have been piling on longer-tenured, high-yielding Pakistan Investment Bonds (PIBs) onto their balance sheets.

HBL and NBP were responsible for over half (Rs20.74bn) of the cumulative capital gains realised by the top 10 banks in the first three quarters of this year

While yields on PIBs have followed the downward trajectory of the policy rate since last year, their longer duration has meant that banks keep on enjoying higher yields.

For instance, the cut-off yield on three-year PIBs issued in July 2013 was 10.3261pc, while that on the bonds issued on October 8 was 7.1967pc. During this three-year period, the highest cut-off yield on three-year bonds was 12.0862pc (in December 2013). This means that a bank that bought that bond and is still holding it is enjoying a coupon rate of over 12pc, while the prevalent rate on a bond of the same duration issued last month is hovering around 7pc.

“[Banks’] profitability will remain closely linked to the strength of the government, as the [their] investments in high-yielding government securities account for around half of their net interest income,” wrote Elena Panayiotou, assistant vice president at credit ratings firm Moody’s, in a recent research report.

However, that represents just one part of the equation. Banks of all sizes have resorted to booking hefty capital gains by selling their government securities in the secondary market to shore up their overall earnings this year.

During 9MCY15, the top 10 banks booked a cumulative Rs38.8bn in capital gains — up a significant 138pc from the Rs16.3bn they had booked in 9MCY14.

Apart from Allied Bank, all the banks under review booked significantly higher capital gains this year than they did last year.

In terms of percentage, Bank Al Habib’s capital gains increased the most, going from just Rs0.3m in 9MCY14 to Rs228.5m in 9MCY15. Next was Habib Bank, which booked over Rs10.56bn in capital gains this year against Rs886m last year.

In fact, HBL and state-owned National Bank of Pakistan were responsible for over half (Rs20.74bn) of the cumulative capital gains realised by the top 10 banks in this year’s first three quarters.

Apart from low interest rates, banks have also been under pressure from the 4pc ‘super tax’ and some other fiscal adjustments imposed on the industry in the FY16 budget. Therefore, they have increasingly relied on the non-core segment to shore up their after-tax profits. And capital gains are one of the biggest sources of income under this head.

For instance, Habib Metropolitan Bank realised 465pc higher capital gains (worth Rs4.5bn) in 9MCY15. This contributed heavily to the 92pc year-over-year growth in its post-tax earnings in the period, which reached almost Rs6bn.

Similarly, Bank Alfalah recorded 130pc higher capital gains in the nine-month period, while its after-tax profit grew 50.6pc to Rs6.05bn.

Not all banks give a breakdown of the sources of their income from capital gains in their quarterly financial reports. One of the firms that did provide one, Askari Bank, specified that almost Rs2.46bn (78pc) of its overall capital gains of Rs3.14bn in 9MCY15 came from the sale of government securities.

By October 31, scheduled banks were sitting on around Rs3.09tr worth of PIBs and another Rs2.56tr worth of Treasury bills, SBP data shows.

“By selling these sizable in increments, banks are likely to keep on booking capital gains in the near future and puff up their earnings. Besides, banks continue to eagerly await a reversal in the central bank’s loose monetary policy, as policy rate hike(s) will automatically translate into higher yields on freshly issued government debt,” remarked one market source.

Equities: Nonetheless, not all of the capital gains have come from the banks’ bond portfolios. While their magnitude may have been lower, but gains realised from equities have also added millions to banks’ bottom lines this year.

From January 1 to last Wednesday, banks and development financial institutions sold a net Rs6.92bn worth of equities, likely resulting in billions more in capital gains for the industry.

“Banks are naturally among the biggest players in the equity market because of their liquidity levels. And the stock market this year has witnessed plenty of volatility, granting many opportunities to skilled investors, including banks, to make quick money from short-term trading,” remarked Zeeshan Afzal, head of research at Taurus Securities.

He added that banks’ reliance on capital gains in particular and on the non-interest income segment in general will only increase from next year when the first batch of PIBs start maturing, putting simultaneous pressure on their top and bottom lines.

Published in Dawn, Business & Finance weekly, November 23rd, 2015