The investment of commercial banks in government securities has been phenomenal over the last 14 years, having surged to over 90 percent by the end of 2020 mainly due to the attraction of easy and risk-free returns.
According to the analysis by the State Bank of Pakistan in its Financial Stability Review (FSR), the banks’ investment shares in various long-term to short-term securities of the government had surged from 76.74 percent in 2007 to 90.65 percent in 2020.
The latest available data reported that the investments in various government securities, including Market Treasury Bills, Pakistan Investment Bonds, and Government Ijara Sukuk, had surged to Rs. 11.39 trillion by the end of March 2021. The remaining less than 10 percent investments were usually parked in various financial instruments, including mutual funds, terms finance certificates, etc. Consequently, the share of the total investments in the total assets had risen from 24.74 percent in 2007 to 47.50 percent in 2020, the report added.
The banks’ returns on investment (ROI) had varied from 6 percent to 12 percent over the last 14 years depending on the prevailing policy rate. At present, the ROI from the securities stands at 10 percent despite the policy rate having stood at 7 percent for quite a sustainable period.
The profit margins due to the interest rate dynamics and lower demand for financing from the private sector also contributed to the portfolio build-up besides the government’s support for the fulfilling of its fiscal needs over the period.
The interest rate dynamics also affected the structure of the investment portfolio because when the government offers higher interest rates after high policy rates, the investment of the banks also reflects the same positive trends.
This phenomenon, in fact, also reflects the business cycles and the underlying imbalances of Pakistan’s economy that are facing fiscal deficits and the government’s persistent demand for bank credit.
While the interest rates rise, the aggregate demand, particularly the credit demand by the private sector, softens and it becomes more lucrative for banks to invest in risk-free securities. Accordingly, the banks’ portfolios of government securities have accumulated over the years.
As the banks invested more of their funds in government securities over time, the incomes from these risk-free securities increasingly contributed to the total interest income. The share of the interest income from government securities had increased to 49.26 percent in 2020 from just 13.75 percent in 2007. These statistics indicate the growing importance of income from investments in government securities in banks’ profitabilities.
Upon realizing the importance of the returns from investments in government securities, the banks attempted to have an optimal portfolio mix in which the higher income-generating long-term bonds are sufficiently represented.
Moreover, the government’s strategy to improve the maturity profile of its debt also contributed to the changes in the investment portfolio mix of the banks. Accordingly, the share of long-term (LT) investments in the total government securities increased to 45.20 percent in 2020 (13.38 percent in 2007), while banks’ exposure in short-term (ST) investments declined to 38.13 percent (57.68 percent in 2007), the report said.
Government’s Reliance on Banks Increases Further
The analysis reveals that the government’s reliance on the banking sector for fiscal needs has steadily increased in the previous 14 years, and consequently influenced the balance sheet structure of the banking sector.
With increased exposure in government securities, the share of interest earnings from government securities in the total interest income had reached around 50 percent in the calendar year 2020 (CY20). The level of the interest earnings on these securities depends mainly on the volume of investments which is determined by the financing needs of the government and the prevailing policy rates.
In CY20, the increase in the tenure of the securities had led to a higher return on government securities, although the policy rates had been cut significantly during the year.
It is critical to note that the persistence of fiscal deficits and the high demand for bank credit may have affected the risk appetite of the banks and weakened their true economic role of financial intermediation, and this may have far-reaching repercussions for the future economic growth of the country.
However, it is necessary to strike a balance between financial stability and due risk-taking for effective financial intermediation between general savers and private sector enterprises. Hence, a comprehensive approach is required from all the stakeholders.
The banks need to enhance their roles in the provision of credit to the private sector, and particularly to private enterprises and high-potential sectors like SMEs, and Agriculture and Mortgage Finance.