The government’s attempt to push banks toward greater private sector lending through tax penalties appears to have largely failed, with evidence suggesting that banks would rather absorb higher taxes than significantly expand lending to small businesses and other riskier borrowers.
For years, policymakers have been concerned that banks are channeling too much money into government securities instead of financing economic activity.
To change that behavior, the government introduced additional tiered taxation on banks whose Advances to Deposits Ratio, or ADR, remained below 50 percent. The measure was intended to encourage banks to lend more of their deposits to businesses and consumers rather than parking funds in government debt.
However, according to a policy brief by the Karachi School of Business and Leadership, the strategy produced limited results. Following resistance from the banking industry, the government eventually replaced the ADR linked levy with a higher tax rate of 44 percent.
The report argues that this outcome effectively demonstrated how highly banks value avoiding additional private sector lending, suggesting that the perceived risks of such lending outweighed the cost of paying more tax.
The reluctance stems from the economics of banking. Lending to businesses requires extensive underwriting, consumes regulatory capital, and exposes banks to defaults, provisioning costs, and lengthy recovery processes. Small and medium enterprises are considered particularly difficult borrowers because many operate with limited documentation, weak collateral, and short credit histories. As a result, banks often view SME financing as carrying significant risk relative to the potential return.
Government securities offer a very different proposition. Treasury bills, Pakistan Investment Bonds, and sovereign sukuk provide attractive returns, carry a zero risk weighting under banking regulations, and require minimal administrative effort.
The report notes that Pakistan’s banking sector has become increasingly concentrated in government paper, while the country’s private sector credit remains low by regional standards. With ADR levels hovering below 40 percent in recent years, access to credit has become particularly challenging for SMEs, which receive less than 10 percent of total private sector lending.
The government’s pressure on the sector has not stopped with ADR related measures. Banks have also faced a series of additional taxes in recent years, including the permanent super tax and a one time windfall tax that allowed authorities to recover Rs. 23 billion from 16 banks in a single day.
According to the report, the effective tax rate on banking profits has climbed to around 55 percent, one of the highest levels faced by the sector. Yet despite the heavier tax burden, banks have not dramatically altered their lending preferences.
While policymakers can use taxation to influence behavior, the report suggests that banks will remain reluctant to expand lending to SMEs unless concerns around documentation, collateral, recovery mechanisms, and credit risk are addressed.
Until those issues are resolved, forcing banks to lend may prove far more difficult than simply raising their taxes.