ADR tax sparks legal showdown for Pakistan banks

November 18, 2024 (MLN): All eyes have turned to Pakistan’s commercial banks after a recent court order granted temporary relief to numerous banks from the hectic incremental tax on Advances-to-Deposit Ratios (ADR) falling below the 50% benchmark.

Concerns grew ever since the introduction of this additional tax—initially imposed in 2022 and later extended into 2023—with the objective to encourage lending to the underserved private sector.

Apparently, the government wants to leverage these banks' lending to help expand the private sector's activities in the country. This, in turn, would help boost growth and capture more tax revenue—a much-needed step to achieve the Rs12.97tr tax collection target for FY25.

Recent years have been the most money-making for commercial banks, as they booked substantial interest income due to rising interest rates, which boosted yields on government bonds—their most favored investment choice.

Accordingly, in 2023, the banking sector experienced a phenomenal year, with the majority of banks reporting record-high profits and dividend payouts.

As addressed earlier, the extreme profit booking along with extremely low levels of ADR is attributed to the sector's robust investment-to-deposit (IDR) figures.

The average IDR as of September 2024 reached a staggering 94.82%, with few of the banks, even exceeding the 100% mark. This means that these banks are investing more than the total amount of their deposits.

Examining the investment portfolio of UBL and NBP, the banks with the highest IDR, it can be drawn out that the majority of these investments are in the government’s safe hands securities such as Market Treasury Bills (MTBs) and Pakistan Investment Bonds (PIBs).

Hence, with these government securities providing an assured and a greater return, these commercial banks prefer not to lend to the private sector, as doing so would result in a high opportunity cost.

The introduction—or perhaps the fear—of this additional tax has shown some positive results, as loans to the private sector have seen a notable increase of nearly Rs824bn since September.

Car financing, which is considered the key gauge for assessing private sector loans, recorded its first rise after 26 months of consecutive decline.

The profit rally still continued in the recent quarters of 2024 on expanded banking operations, economic recovery, stable forex conditions, and more profitable trades in securities. However, the monetary easing struck banks and their growth in interest incomes and eventually bottom line capped significantly.

Nonetheless, the banking sector stands as the most profitable listed sector of the Pakistan Stock Exchange. More interestingly, banks have already proven themselves to be the most contributors to the government’s treasure.

For better reference, we can set the KSE-100 index as the benchmark and assess how much the comprised banks of the index contributed to the total tax collection.

Less surprisingly, the share of the thirteen banks stood at an astonishing 52.43% in the total Rs324.66bn tax expenditure for the quarter ended September 30, 2024 (Q3 CY24).

Moreover, the effective tax rate for the sector as a whole stood at 49.07%, with banks including MEBL, NBP, and SCBPL crossing the 50% mark and the others remaining close to it.

By viewing this, it becomes understandable why Muneer Kamal, Chief Executive Officer at Pakistan Banks’ Association, argued that the sector is already highly taxed.

Askari Bank in its legal challenge argued that this incremental tax oversteps the scope of a Money Bill.

Retroactively, it increases tax on investments in Federal Government securities, which is unfair since these investments did not mature within the financial year, AKBL noted.

Moreover, it conflicts with Section 46B(3) of the State Bank of Pakistan Act, 1956, as only the State Bank of Pakistan has the authority to regulate banks, not the Tax Department.

The Islamabad High Court, responding to similar complaints filed by various listed banks, has recently restricted the government from collecting tax based on bank lending until a final verdict is issued on the petitions submitted by these banks.

December 03, is the next hearing date, which is expected to provide a clearer sense of the final outcome.

However, the point here is that the private sector and its operational efficiency are now emerging as key priorities for the government.

The International Monetary Fund (IMF), during its recent staff-level visit, urged the Pakistani government to reduce state intervention in the economy and promote competition, aiming to foster the growth of a dynamic private sector.

As banks are the main drivers of private sector lending, restrictions on charging taxes on low ADR would reduce the willingness of banks to lend.

The point here is not about determining what is right or wrong but rather assessing the situation of the sector and the economy as a whole.

The economy needs revival, which can be partially achieved by fully supporting the private sector through loans at reasonable markups. On the other hand, there is a debate surrounding the payout of approximately 50% of pre-tax profits earned by banks.

On a positive note, there are signs indicating that lending to the private sector might increase despite the imposition of this income tax.

Pakistan’s central bank has already initiated the monetary easing with the policy rate down by 700bps since June.

Considering the elevated real interest rates, the SBP is expected to implement further significant rate cuts.

As interest income is the primary revenue source for banks, a reduction in interest rates will decrease the risk-free return on government securities. This could shift banks' preferences towards loans, cash credits, and running finances, ultimately boosting their lending activity.

Banking Statistics

As of September 2024, the average ADR of the banking sector stood at 39.49%, with nearly only two out of the nineteen members appearing to be exempt from the additional tax.

Namely, these banks are SBL and JSBL with strong ratios of 66.61%, and 54.02%, respectively.

Following closely with an ADR above 40% but below the 50% benchmark, are HMB, FABL, ABL, MEBL, BOP, and BAFL, which may face an incremental tax of 10%.

Meanwhile, the remaining 11 banks, below the 40% threshold are set to face 16% extra tax. Specifically, BML, SCBPL, UBL, and BOK are on the red alert with the lowest ADR of 31.1%, 25.8%, 25.7%, and 25.3%, respectively.

Compared to the statistics from June 2024, several banks have reported worsening conditions in their ADR, including SBL, AKBL, FABL, BOK, MEBL, BIPL, SNBL, SCBPL, BOP, NBP, and BAHL.

Their ADRs have declined within a range of 100 basis points to as much as 1,800 basis points, indicating a significant struggle to increase lending.

Conversely, banks that have shown improvement in lending and possibly their ADRs include UBL, MCB, BML, HBL, BAFL, ABL, HMB, and JSBL.

With the majority of banks reporting lower comparative ADRs, the average ADR of the listed banking sector declined to 39.49%, compared to 40.26% in June 2024.

This underscores the need for measures to incentivize or charge banks with low ADRs, encouraging them to increase their lending activity.

Copyright Mettis Link News