For all their pomp, and obsession with optics, banks in Pakistan do not actually do that well. And Murad Ansari, analyst at EFG-Hermes, does not mince words about the country’s banking sector, calling it the worst performing sector this year, which has also lagged in the recovery cycle, in a note issued to clients on June 12. In fact, Ansari reduced banks’ expected earnings by between 26% and 42%, mostly due to the combined shock of a fall in interest rates and a fall in economic activity.
To reach his thesis, Ansari looked at seven different Pakistani banks: Habib Bank (HBL), United Bank (UBL), MCB Bank, Meezan Bank, Bank Alfalah, National Bank of Pakistan (NBP), and Allied Bank. The key threats to these banks are the following: a compression in net interest margins in the second half of 2020 and first half of 2021; a weakness in non-interest income; and higher credit costs.
However, across the board, Pakistani banks are liquid, with a loan to deposit ratio at 55%, meaning that a large portion of their deposit base is deployed not in loans that are payable on a set schedule but in tradable securities like government bonds, which they can sell at any time if they need to raise the cash.
They also have strong capital buffers, with capital adequacy ratio at around 17% (the State Bank of Pakistan only requires it to be 10%). Furthermore, some banks will be more resilient to interest pressure, have stronger capital ratios, and will also have the ability to sustain dividends. In this regard, MCB comes out on top, followed by Meezan and UBL. Ansari is generally positive about the other banks too, but is decidedly neutral about Allied Bank.
First, let us walk through the risks. Between March and May 2020, the central bank drastically cut the benchmark interest rate from 13.25% to 8%. This reversed the outlook for net interest margins. In the short term, this is likely to not be an issue, and it will lead to quicker deposit repricing. But issues could crop up as the loan book gradually reprices.
Net interest margins (NIMs) – the difference between the interest rate banks pay out to depositors and the rates they charge borrowers on loans – are expected to decline to 4.3% in 2020, and 4% in 2021, which is lower than EFG-Hermes’ earlier expectations of 5% and 5.5% respectively. In particular, the aggregate net interest margins of four banks are expected to decline between 10 to 30 basis points (bps) in 2021. (One basis point is one-hundredth of one percent.)
However, this risk can still be mitigated. The investment book – which consists almost entirely of government bonds and is between 40% to 45% of total assets – can limit the impact on net interest margins.
“Not only will the investment book provide support to NIMs from falling interest rates, they also provide capital gain opportunities to offset the earnings pressure from weak revenues and higher credit costs,” notes Ansari. In this area, HBL and MCB are best positioned with unrealised capital gains on long-term government bonds, known as Pakistan Investment Bonds (PIBs).
The second risk is the shock to non-interest income, or fee income. Branch banking and trade related fees make up almost one-third of total fee income for banks, but is likely to be affected by the lockdown. Bancassurance and remittances fees, which make up 15% of fee income, are also likely to be dented in 2020. In total, Ansari predicts the fee income to decline by 12%. In this area, NBP is less vulnerable, as almost half of its fee income comes from government transactions. However, Meezan’s trade and guarantee fees account for 35% of its total fee income, which puts it in a precarious spot.
The third risk is higher credit costs. According to Ansari, it is difficult to see any significant increase in non-performing loans: yes, there is a weaker economy, but also there has been a sharp fall in interest rates. Additionally, Ansari takes the view that one should not compare this crisis to the crisis of 2008-10, as banks have a much lower exposure to small and medium enterprises and consumer sectors (at 12% of the loan book) then they did back then (at 30%).
“We forecast aggregate credit costs of our covered banks to rise from 45 bps in 2019 to 97 bps in 2020 and 125 bps in 2021,” says Ansari.
Loan growth, however, will remain muted, with an expected deposit growth of 6% to 10% between 2021 and 2024.
That being said, it is important to note that overall banks’ balance sheets are a lot healthier now. In addition, the central bank has provided some respite to banks, such as the deferment of principal repayments for a 12-month period and relaxations offered for rescheduling of loans. Ansari expects dividends to actually be maintained at 2019 levels, or a dividend yield of 8.7%.
At a more granular level, Ansari rates MCB as the best equipped to withstand the current economic shock to its profitability.
“The bank has built a high yielding bond portfolio that should support NIMs in the near term, while its strong deposit franchise should help lower funding costs. Moreover, within our coverage, MCB has the highest breakeven credit cost, allowing it to absorb credit quality deterioration,” says Ansari.
Other honourable mentions include UBL, which has one of the ‘most formidable’ domestic deposit franchises in the country, which should partially help offset pressure on net interest margins. The bank also has lower unrealised gains on the bond portfolio, compared to other banks.
Meezan Bank is well positioned to handle lower interest rates on net interest margin, since it has no regulatory restrictions on the pricing of savings deposits. (Conventional banks must pay an interest rate of 5%, or the State Bank’s discount rate minus 2.5%, whichever is lower. Islamic banks face no such restriction.) Ansari notes that the issuance of Sukuks by the government also provided the bank’s ability to deploy liquidity.
The bank Ansari is not so keen on? Allied Bank has the most corporate loans on its loan books, which are frequently repriced. The bank also added 100 branches, which will weigh on operating costs. On the bright side, however, “the bank’s conservative lending practices should lead to lower asset quality risks,” says Ansari.