Moody’s Investors Services (Moody’s) is sustaining a stable outlook for Pakistan’s banking sector (B3 stable). Its latest report on Pakistan revealed that this balances good economic momentum and growing financial inclusion that are boosting lending opportunities against local political uncertainty and higher inflationary pressures due to the Russia-Ukraine military conflict.
It expects real GDP growth of between three and four percent for FY 2022 and between four and five percent for FY 2023, with credit growth surpassing 12 percent.
Pakistani banks successfully navigated the pandemic and Moody’s expects the nonperforming loans (NPLs) to remain high but broadly stable at around nine of the gross loans. Profitability will rise moderately, with a return on assets of around one to 1.1 percent, supported by new business generation, and gradually recovering net interest margins.
Investment gains are likely to be lower but Moody’s expects dividend payouts to rise this year while earnings should be sufficient to keep capital at current or modest levels. Pakistani banks will remain deposit-funded and liquid. These are credit strengths but their high exposure to Pakistan government securities means their credit profiles are anchored to the low-rated sovereign.
The report read: “Our stable outlook is underpinned by an expanding economy and banks’ resilient financial metrics”.
Operating conditions will be supportive for banks, despite new pressures, and the Russia-Ukraine military conflict will pressure Pakistan’s current account deficit via higher oil prices while the rising inflation will weaken private-sector spending. Furthermore, sharp increases in interest rates will also weigh on private-sector investment.
“We expect an economic growth of 3%-4% for 2022 and 4%-5% for 2023, as the government’s reform agenda and the China-Pakistan Economic Corridor (CPEC) helps boost economic growth,” Moody’s explained.
Initiatives to deepen financial inclusion, including the introduction of an instant digital payment system and simplified account opening procedures, offer new lending opportunities for banks. Government support for specific sectors, such as a subsidy scheme for housing finance, subsidized interest rates, and partial credit guarantees for small businesses and agriculture will also boost credit demand.
Moody’s also expects credit growth to exceed 12 percent in 2022.
Asset risk is mainly linked to banks’ high exposure to government securities. Pakistani banks’ exposure to government securities accounts for 45 percent of their total assets, and around seven times their equity, which is one of the highest levels among Moody’s rated banks globally. This exposure links their credit profiles to the sovereign’s.
After a moderate rise in problem loans during the pandemic, Moody’s now expects these exposures to stay around nine percent of the gross loans for the rated banks. The loans to the sugar, textiles and leather, and electronics sectors will be the most vulnerable.
The phased introduction of the new IFRS 9 accounting standard, which contains stricter rules on loan-loss provisioning, will likely increase provisioning needs. However, these already stand at around nine percent of the gross loans, almost fully covering the problem loans.
Furthermore, capital buffers will be stable but modest. According to data from the State Bank of Pakistan (SBP), the banking sector’s capital-to-assets ratio stood at 6.3 percent in December 2021. The sector’s reported Tier 1 capital was 13.5 percent of the risk-weighted assets.
“Once we risk-weight government securities at 100% in line with the government’s B3 credit rating, however, tangible common equity (TCE) to adjusted risk-weighted assets drops to a modest 7.4% for the rated banks,” Moody’s noted.
However, Moody’s own stress scenario1 projects a severe impact although capital buffers remain broadly stable under its baseline scenario. More specifically, Moody’s expect banks to increase their dividend payout ratios for 2022 to pre-pandemic levels of around 50 percent to 60 percent but the retained earnings will be sufficient to fund the balance sheet growth and keep reported capital ratios steady.
Moody also envisions that profitability will rise moderately.
“We expect Pakistani banks to deliver an average return on assets of around 1.0% to 1.1% in 2022. Earnings will be supported by balance sheet growth of over 15% and gradually widening interest margins due to higher interest rates,” it said in the report.
It mentioned that “Rates have risen 275 basis points during 2021 and further increases are envisaged in 2022. We expect provisioning costs to hover around their way through-the-cycle levels of 60-80 bps of gross loans while operating costs will increase broadly in line with inflation”.
Foreign-exchange income and securities gains and losses will remain a volatile part of revenues and vary considerably among banks., and funding and liquidity conditions will remain stable. Deepening financial inclusion and funds from non-resident Pakistanis are broadening the inflows of domestic deposits that fund the banks’ lending activities.
Moreover, customer deposits accounted for 67 percent of the total assets as of end-December 2021. Liquidity is also solid, with around 12 percent of assets held as cash and interbank placements, and an additional 45 percent invested in government securities (a large proportion of which can be repoed with the central bank in case of need).
The SBP has also introduced additional Shariah-compliant liquidity facilities for Islamic banks. Some pressure points remain but these will be manageable. The introduction of a Treasury Single Account will lead to modest deposit outflows and Pakistan’s inclusion on the Financial Action Task Force’s (FATF) grey list of countries with deficient anti-money laundering regimes is being addressed with 26 out of the 27 actions required already completed.
Pakistani banks hold a high share of market funding (22 percent of the total assets as of end-December 2021) but mainly in the form of interbank and SBP repo facilities that are used for ‘carry trade’ transactions. Related liquidity risks are, therefore, contained although such activities expose banks to additional credit and interest-rate risks.
The probability of government support for failing banks is high. The government remains willing to support the country’s banks in a crisis, given banks’ role as the main source of financing for the government and the need to avoid disruptions to the payments system. However, its ability to do so is limited by the fiscal challenges reflected in its B3 credit rating.
In recent years, authorities have enhanced their bank resolution tools to include the write-down of shareholders’ capital and subordinated debt instruments; requesting the injection of new capital; and facilitating a merger or acquisition by another bank. The amount of insured deposits has also doubled to Rs. 500,000 per depositor, covering approximately 98 percent of depositors and 20 percent of the total deposits.
