BY lowering interest rates and tightening the risk-free banking spread enjoyed by financial institutions, the central bank has virtually ensured that banks would need to go back to acting as financial intermediaries to make their bread and butter.

The latest round of monetary easing set from last November, when the State Bank of Pakistan (SBP) had reduced the discount rate from 10pc to 9.5pc. And in its monetary policy decision last month, it had reduced this rate to 7pc — a 300 basis point (bps) drop in seven months.

During the same period, weighted average yields during Pakistan Investment Bond (PIB) auctions (for the three-year bond) went down from 10.394pc (November 20) to 7.365pc (May 21) — a corresponding drop of around 300bps.

This will undoubtedly have a negative impact on sector earnings.

The situation provides an opportunity to banks to finally diversify their asset books in favour of advances, which have taken a backseat these past few years

But the situation also provides an opportunity to banks to finally diversify their asset book in favour of advances, which have taken a backseat these past few years. Record-low interest rates and the various energy and infrastructure projects that are expected to come online owing to the China-Pakistan Economic Corridor are both expected to spur private-sector credit demand. But will they?

Therefore, it would be the net impact of these two factors — i.e. lower yields on government debt and a potential increase in credit demand — that would determine the financial performance of individual banks.

However, this impact would not be uniform across the industry. Sector watchers point to a number of factors that will determine which banks’ bottom lines will get hit the hardest in the short- to medium-term.

“Banks with higher zero-cost current accounts, stronger revenue contribution from non-interest components, longer duration asset mix, substantial international book and lower administrative cost burden are likely to prevail much better against the rest,” wrote Kasb Securities analyst Farid Aliani in a recent research note.

Classification of PIB portfolio: Apart from the quantum and maturity profile of PIBs on a bank’s balance sheet, it will also matter which of the three holding categories it classifies them in: available for sale (AFS), held for trading (HFT) or held till maturity (HTM).

With interest rates dropping, the banks have locked in higher yields for the medium-term, particularly on longer duration bonds. And with interest rates inversely related to bond prices, banks are likely to benefit from sizable revaluation gains on their PIB portfolios.

But the classification matters mainly because of where the unrealised gains will be recorded. Revaluation gains in the HTM portfolio are reflected as unrealised gains in the profit/loss (P/L) statement. Therefore, banks that have the bulk of their PIBs in the HTM category will be able to record hefty unrealised capital gains, which will provide some cushion to their after-tax earnings.

On the other hand, unrealised gains on securities in the AFS portfolio are routed through net assets on the balance sheet; they have no impact on the firm’s earnings.

An analysis of the first quarter (1QCY15) accounts of the top nine conventional commercial banks showed that almost all of them had stocked most of their PIBs in their AFS portfolios. The exceptions were Allied Bank and Bank Al Habib, which had more PIBs in their HTM portfolios than in AFS or HFT.

However, with the structural changes in the interest rate corridor introduced in May, it would be interesting to see whether these banks will realign their investment books in the quarter ending June 30. In case they go for this realignment, they will be able to report unrealised gains on their PIBs in the P/L account for the second quarter.

Lending: Based on the 1QCY15 accounts of the top nine conventional banks, the picture on the lending front appears quite dismal. Net advances of all but two of these nine banks were down from their end-2014 levels.

While an argument could be made about the seasonal nature of fresh loan dispersals, banks lent the private sector just Rs149.35bn during the first 11 months of this fiscal (till May 22), down significantly from Rs325.15bn in the same period of the prior fiscal.

“You have to see the full picture. Firstly, demand for credit is fairly subdued, mainly due to the energy shortage that is crippling manufacturing. Secondly, the law and order situation has made investors exceedingly cautious about getting into new ventures. Thirdly, banks have only recently started to recover from the toxic loans of 2008-10. Therefore, they can hardly be expected to suddenly get into full-blown lending mode,” Taurus Securities analyst Zeeshan Afzal told this writer, sharing views commonly expressed by banking circles.

Size of the bank: General consensus on the street remains that the mid- and small-tier banks would be harder hit by the regulatory changes than the bigger ones.

“The downward earnings revision for mid-tier banks far outpaces that for the Big-5 due to their higher administrative expenses, fewer avenues to augment non-funded income and higher risk on asset re-pricing due to their higher advances-to-deposit ratios,” pointed a research report by BMA Capital.

The Big-5 banks also have the highest share of current and savings accounts (Casa) in the industry, at 56.9pc by end-March. The next five banks only had 21.5pc of all industry Casa deposits.

The top five banks also have over 55pc of the industry’s investments. However, as a percentage of total investments, the mid-tier banks (ranked sixth to 10th) have more of their investments parked in government securities (95pc) against the top five (88.4pc).

Non-interest income: Naturally, banks with solid and sustainable non-core income streams will be able to better weather the impact of the discount rate cut. Banking analysts frequently mention United Bank Ltd in this regard, as the bank’s non-interest income forms nearly 30pc of its overall revenues.

Published in Dawn, Economic & Business, June 8th, 2015

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