SBP has changed its stance on MDR; here is what you need to know

The State Bank of Pakistan (SBP) has announced the removal of the Minimum Deposit Rate (MDR) for deposits held by financial institutions, public sector enterprises, and public limited companies. Effective January 1, 2025, the new policy will apply exclusively to individual depositors, allowing banks greater flexibility in negotiating rates with corporate clients. 

This development, which has the potential of completely changing the banking landscape of Pakistan, has sparked significant interest in financial circles, with market watchers anticipating its impact on the profitability of banks.

The SBP has also introduced a new profit-sharing benchmark for Islamic Banking Institutions (IBIs). Under this framework, IBIs must now pay profit on savings accounts equivalent to at least 75% of the weighted average gross yield of their pools. This calculation will exclude pools associated with Shariah-compliant standing ceiling facilities and open market operations. Previously this requirement used to be around 50% for IBIs.

Following this development the banking sector has seen significant activity. While conventional banks are set to gain from this, Pakistan’s biggest IBI, Meezan Bank has lost more than 10% of its value during the day’s trade.

For years, the MDR has acted as a safeguard to ensure a minimum return on deposits, protecting depositors while maintaining a floor for interest rates. Simultaneously, it has acted as a buffer for IBIs where they can have a separate, often more profitable tier of banking.

By exempting corporate deposits from this requirement, the central bank is effectively handing conventional banks an opportunity to reduce the cost of funds on a significant portion of their deposit base. This change comes amidst growing competition in the financial sector and follows persistent rumors within banking circles about a possible policy shift.

What is MDR?

The Minimum Deposit Rate (MDR) is a regulatory mechanism introduced by the State Bank of Pakistan (SBP) to ensure fair returns for depositors in conventional banks. Before its implementation, banks were free to decide the returns on savings accounts, often offering negligible rates.

In 2008, the SBP mandated a minimum annual profit rate of 5% on savings accounts. This rate was later adjusted to 6% in 2012 and further linked to the SBP’s policy rate in 2013. Under this framework, banks must offer returns at least 1.5% below the prevailing policy rate. The MDR was introduced to narrow the gap between high policy rates and low deposit returns, which previously hovered around a 9.5% differential.

However, Islamic banks are exempt from the MDR due to Shariah compliance. Islamic banking operates on a profit-and-loss sharing model, which prohibits fixed returns. Instead, their returns are approved by Shariah boards and submitted to the SBP. Islamic banks also argued that a lack of mature and liquid investment avenues made it difficult to guarantee fixed returns, and such flexibility encouraged their growth in Pakistan’s banking sector.

In its own way, MDR safeguarded the interest of the depositors while simultaneously allowing Islamic banks to grow. But what effect does removing MDR on corporate clients and adjusting it for IBIs have on the banking landscape? 

The Corporate Deposit Equation

According to a report by Topline Securities, corporate deposits constitute a substantial 53%—or approximately Rs 14 trillion—of the total Rs 27 trillion in deposits across Pakistan’s banking sector, as reported in 2023 financial statements. 

Banks with a heavy reliance on corporate deposits, such as the Bank of Punjab (BOP), Bank of Khyber (BOK), Samba Bank (SBL), National Bank (NBP), and Askari Bank (AKBL), where corporate funds account for 65-88% of total deposits, stand to gain significantly from the new policy. Conversely, other major banks like MCB Bank, Bank Al Habib (BAHL), Habib Bank Limited (HBL), and United Bank Limited (UBL), whose corporate deposit exposure ranges from 35-40%, may see less dramatic benefits but are still poised to reduce their overall funding costs.

The benefit for the banks is that the removal of the MDR on corporate deposits allows banks to negotiate rates directly with corporate clients, potentially lowering deposit costs by 50 to 100 basis points. 

According to preliminary analyses, such a reduction could translate to an average 7% boost in bank earnings. However, the competitive landscape may limit the extent of these savings. Banks will also need to tread carefully to avoid losing deposits to alternative investment options, such as Treasury Bills, which offer attractive returns.

The policy change also comes in the context of rumours surrounding the SBPs potential monetary expansion. The

Implications for Islamic Banks

The new profit-sharing benchmark for Islamic Banking Institutions (IBIs) asks IBIs to now pay profit on savings accounts equivalent to at least 75% of the weighted average gross yield of their pools. This calculation will exclude pools associated with Shariah-compliant standing ceiling facilities and open market operations.

What this change in policy does is that it imposes a form of minimum ratio on IBIs without affecting their shariah compliance, while also simultaneously forcing them to venture towards higher yielding products to increase profitability.

To show this, let us consider the example of Meezan Bank. The implications for Meezan Bank, Pakistan’s largest Islamic bank, are particularly noteworthy. Based on its current gross yield on assets of 15.2%, Meezan will be required to pay a minimum return of 11.4% on savings accounts. Although the bank’s overall cost of deposits, adjusted for current accounts, is 13.1%, the granular details reveal a more nuanced challenge.

A report by Topline Securities suggests that a significant portion of Meezan’s savings deposits are tied to lower-yielding products, such as the 7.5% Meezan Bachat Tier II account. 

As a result, the bank may need to raise rates on retail savings accounts by an estimated 1.5-2.5%, impacting profits. Analysts estimate this could result in a pre-tax hit of Rs 15-20 billion, or Rs 7.5-10 billion after tax, translating to an 8-11% reduction in per-share earnings. 

Unsurprisingly, Meezan’s stock took a sharp hit, dropping 10% during trading and at one point losing 15% from its peak.

These policy changes mark a significant shift in Pakistan’s banking regulation, aligning conventional banks and Islamic banking institutions with divergent strategies to optimize deposit management. For conventional banks, the removal of the MDR on corporate deposits enhances flexibility, especially for those with a high concentration of such deposits. However, the competitive landscape will likely moderate the benefits, as corporations retain strong negotiating power.

For Islamic banks, the emphasis on transparency and adherence to Shariah principles will require recalibrating their deposit structures and yield-sharing models. While the policy underscores the SBP’s commitment to bolstering Islamic finance, it also presents near-term challenges for profitability in the sector.

As the banking industry adapts to these changes, analysts and stakeholders will be watching closely to assess how individual banks respond to the opportunities and constraints introduced by this regulatory overhaul. Further clarifications from the SBP and detailed responses from the banking community are anticipated in the coming weeks.