A sudden and significant shift has emerged in Pakistan’s banking sector as certain banks race to meet the government-mandated Advances to Deposit Ratio (ADR) threshold of 50%. The primary motivation for this rush is to avoid an additional tax imposed on banks with lower ADRs, which has been in place since 2022 and was extended into 2023. This tax initiative is part of the government’s broader strategy to encourage lending to the private sector, aiming to boost economic activity and address liquidity challenges within the economy.
The Race to Avoid Additional Taxes
To achieve the 50% ADR requirement, some banks have adopted an aggressive approach by lowering their lending rates to unprecedented levels. Reports suggest that lending rates have dropped to as low as 3-4%, a substantial difference from the benchmark 6-month Karachi Interbank Offer Rates (KIBOR) which stands at 14.7%. This discrepancy highlights the urgency among these banks to increase their loan portfolios and escape the additional tax burden. In many cases, banks are offering rates over 1,000 basis points lower than KIBOR to attract borrowers.
As of June 2024, the average ADR across the banking sector was 40.26%, with only three out of 19 banks having crossed the 50% threshold and thus being safe from the additional tax. These banks include FABL, SBL, and AKBL, with ADRs of 54.68%, 68.13%, and 53.36%, respectively. Meanwhile, banks like MEBL, BOP, HMB, and ABL, which have ADRs between 40% and 50%, are expected to face a 10% incremental tax. On the other hand, banks with ADRs below 40%, such as UBL, SCBPL, and BML, are set to be hit with a 16% extra tax.
Why Do Some Banks Have Low ADRs?
A key question that arises from this scenario is why certain banks have such low ADRs. The answer lies in the banks’ investment-to-deposit ratios (IDR), which reflect a strong preference for investing in government securities over lending to the private sector. As of June 2024, the average IDR for the sector reached a staggering 85.47%, with some banks investing more than 100% of their deposits.
For banks like UBL and NBP, a significant portion of their investments is in safe government securities, including Market Treasury Bills (MTBs) and Pakistan Investment Bonds (PIBs). These securities offer an assured and often higher return, making them a more attractive option for banks compared to lending to the private sector, which involves greater risks and opportunity costs. As a result, many banks prefer to park their funds in these government instruments rather than extending loans to businesses or individuals.
This trend has led to a decline in private sector lending, particularly in areas like car financing. Car financing, a key indicator of private sector borrowing, has seen a consistent drop over the past 26 months, with outstanding loans falling to Rs227.3 billion as of August 2024. The reluctance of banks to lend, coupled with high borrowing costs, has contributed to this decline, making it difficult for the private sector to access credit.
The Additional Tax and Its Impact
The additional tax on banks with low ADRs was introduced to address this very issue. By penalizing banks that do not meet the 50% threshold, the government hopes to push them towards lending more to the private sector, which would, in turn, improve liquidity and stimulate economic growth. The recent drop in lending rates is a direct result of this policy, as banks seek to scale up their advances and avoid the tax penalty.
However, meeting the ADR target is easier said than done. While lower lending rates might attract more borrowers, banks still face the challenge of growing their deposits. Total deposits in scheduled banks surged by 17.9% year-on-year, reaching Rs30.78 trillion in August 2024. This growth in deposits, fueled by higher real interest rates, presents a hurdle for banks aiming to increase their ADRs, as they must lend at an even faster pace to keep up with the deposit growth.
To avoid the additional tax, banks must either reduce their deposits, which is unlikely, or continue to expand their lending aggressively, despite the narrow profit margins. Several banks have expressed confidence in meeting the ADR target by December 2024, but doing so will require sustained efforts and strategic lending practices.
Additional Challenges for Banks
Beyond the pressure to meet ADR targets, Pakistani banks are also grappling with other financial challenges. The State Bank of Pakistan (SBP) has initiated a monetary easing cycle, reducing the policy rate by 450 basis points since June. This has brought inflation down to 6.9% as of September 2024, the lowest level in nearly four years. While this is good news for the economy as a whole, it presents a new challenge for banks, whose primary source of income is interest income. As interest rates decline, banks’ interest margins are likely to shrink further, reducing their profitability.
Moreover, the government’s ongoing debt reprofiling efforts may affect banks’ investments in government securities. In September 2024, the government surprised the market by rejecting all bids for MTBs, signaling a shift in its borrowing strategy. Rather than accepting market rates, the government is now setting its own borrowing rates, which could result in lower yields for government securities. This, coupled with the government’s recent buyback of T-bills, could reduce returns for banks heavily invested in these instruments.
The Road Ahead
Despite these challenges, the banking sector remains cautiously optimistic about its ability to navigate the current environment. With inflation under control and the SBP expected to cut rates further, there is hope that the private sector will begin borrowing more, improving the banks’ ADRs and helping them avoid additional taxes. However, achieving this will require banks to strike a delicate balance between lending, managing deposits, and maintaining profitability.
In the coming months, banks will need to focus on increasing their lending activities while keeping a close eye on their investment portfolios. Government securities, which have been a safe haven for banks in recent years, may no longer offer the same returns, forcing banks to explore other avenues for generating income.
At the same time, the government will need to continue supporting the banking sector through policies that encourage lending without undermining financial stability. The additional tax on low ADRs is just one piece of the puzzle, and broader reforms may be necessary to ensure that banks are able to contribute effectively to Pakistan’s economic growth.
Conclusion
Pakistan’s banking sector is currently navigating a complex financial landscape, marked by efforts to meet ADR targets, manage deposit growth, and adapt to changes in government borrowing strategies. While the recent drop in lending rates is a positive sign for private sector borrowers, banks still face significant challenges in maintaining profitability and avoiding additional taxes. The coming months will be crucial as banks strive to meet the government’s ADR requirements while managing the risks associated with declining interest margins and shifts in the investment landscape.
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