Pakistani banks are introducing loans below market rates to address regulatory pressures and meet the mandated Advance to Deposit Ratio (ADR) targets. This strategy reflects ongoing challenges within the banking sector as it navigates changing economic conditions and evolving fiscal policies.
A report by Insight Securities (Pvt) Limited highlights that domestic banks have experienced exceptional profitability over the past two years. This success was driven by record-high interest rates and resilient asset quality, allowing the sector to remain robust despite macroeconomic challenges. However, recent economic changes, including a faster-than-anticipated decline in inflation and corresponding reductions in the policy rate, have significantly impacted the sector’s Net Interest Margins (NIMs).
Adding to the strain is the ADR tax, which has become a contentious issue between banks and regulators. While many banks have legally challenged this tax and secured temporary relief through stay orders, the levy persists on their balance sheets. To meet ADR benchmarks, banks have adopted strategies such as reducing high-cost deposits and offering loans at below-market rates. These measures, while helping achieve compliance, have led to market distortions and failed to stimulate significant private sector lending.
The effects of these strategies became apparent after September 2024, coinciding with reduced interest rates and improved economic stability. A notable surge in loan advances was observed, suggesting that banks were prioritizing year-end ADR compliance over long-term lending objectives. Concurrently, deposit volumes declined, underscoring the short-term nature of these measures. Insight Securities points out that such taxation policies neither generate substantial government revenue nor effectively stimulate private sector growth.
Recognizing the need for reform, the government has formed a high-level committee chaired by Deputy Prime Minister and Foreign Minister Ishaq Dar. The committee’s objectives include reviewing the legal framework surrounding fiscal measures tied to ADR, exploring alternative taxation on bank profits from government securities, and fostering consensus-driven solutions in collaboration with the banking sector and the Federal Board of Revenue (FBR).
Approximately 70% of banking sector profitability is derived from government securities, making any changes to taxation in this area a critical concern. Analysts at Insight Securities recommend transitioning from a year-end ADR threshold to an average basis. Such a shift would encourage systematic private sector credit flows, allowing banks to base lending decisions on strategic and risk considerations rather than solely on compliance deadlines.
The government’s fiscal challenges are further complicated by stringent revenue targets under the International Monetary Fund (IMF) program. One possible solution being considered is a direct increase in the tax rate on banking sector profits, particularly those derived from government securities. However, this approach could have significant repercussions, with estimates suggesting that a 10% additional tax could reduce banking sector profitability by approximately 19%.
As the sector faces mounting pressure, striking a balance between fiscal objectives and economic growth remains crucial. Collaborative solutions involving regulators, the government, and the banking sector will play a key role in shaping the path forward.