Central banks worldwide lowered the interest rates in 2020 to withstand coronavirus-triggered economic chock. When the world began to normalise from the pandemic, the price levels surged upwards.

Bloomberg Commodity Index, often used as a proxy for global price levels, was up 27 per cent in 2021 and 14pc in 2022. This compelled central banks to tighten monetary policy to tame inflation. However, the magnitude and speed of this action have yielded some ugly results.

Taking the United States as an example, the Federal Reserve (Fed) embarked on a hawkish monetary policy course with nine rate hikes since March last year to achieve the long-term goal of keeping inflation to 2pc.

However, despite the inflation being 5pc year-on-year in March 2023, the Fed signalled that it might pause in the near future to put the brakes on rate hikes to stem the banking sector crisis, which is worsening with each passing day.

A significant chunk of banking money is invested in sovereign debt instruments creating systematic risk

The fallout of the sector began with Silicon Valley Bank’s (SVB) collapse in March. SVB had amassed a sizeable deposit base, with billions pouring in from its tech clientele in the wake of “zero money” interest rates. It had invested money in the long-term US Treasury Bonds.

However, when the interest rates rose sharply, its customers demanded higher returns on deposits, and the bank began incurring losses on these bonds.

A sale of securities worth $21 billion at a loss of $1.8bn sparked panic among its depositors and led to a classical bank run. In the same month, Signature Bank followed suit. The most recent casualty of the crisis has been First Republic Bank.

The common denomination among all is that they had a business model that did not adapt well to rising rates. Resultantly, depositors fled en masse, and the regulator had to step in.

Pakistan’s case is synonymous in terms of monetary tightening but dissimilar in terms of the banking sector’s dynamics. There does not seem to be any element of stress as the Capital Adequacy Ratio (CAR) of banks is above the minimum required threshold. So, there is a capacity to absorb losses, and the sector appears to be sufficiently fortified against any contingency.

However, some structural issues should grab policymakers’ attention. A significant chunk of the bank’s money is invested in sovereign debt instruments creating a systematic risk. It means that the credit ratings of the banks go hand in hand with that of the federation.

Besides, there is crowding out since the country (most of the time) is either part of or seeking an International Monetary Fund programme, which restricts them from borrowing from central banks.

Further, textile is Pakistan’s export cash cow and accounts for roughly two-thirds of national export proceeds. Most of these exports flow to US and European markets. Economic unrest in either or both could potentially hit back at the sector and may impact the repayment of their outstanding loans.

The State Bank of Pakistan’s data reveals that local banks are facing the grave issue of rising Non-Performing Loans (NPLs) due to ongoing economic turmoil.

The net NPLs have seen a colossal 32pc rise from Rs74.8bn in September 2022 to Rs98.7bn in December 2022, while the gross NPLs totalled Rs938bn in December 2022, out of which roughly 75pc is attributed to the corporate sector.

Lastly, few large banks hold the majority of the banking assets. This concentration risk means any chaos at such a bank could bring the entire system to its knees. Having the potential to create a crisis out of thin air, Pakistan would not want to hurt an already limping economy. So, policymakers, regulators, and other relevant stakeholders must ensure efforts aimed at addressing these anomalies.

The writer is a finance professional and a graduate of IBA, Karachi

Published in Dawn, The Business and Finance Weekly, May 15th, 2023