December 1, 2020 (MLN): With a dramatic ninety-degree drop-in policy rate in a short span of time, commercial banks undoubtedly gained more traction to achieve higher profitability. Commercial banks and financial institutions hold the biggest bucket of risk-free government securities and dominate the debt market due to their high participation rate in buying and selling of debt securities.
As all banks have reported third-quarter results, we see that most of the banks’ profits kept on rising regardless of risk associated with the business environment. The cumulative post-tax earnings during 9MCY20 of the 8-top tier commercial banks stood at Rs 130.39 billion, showing positive income growth that appears on the financial statements of Habib Bank (HBL), MCB Bank, National Bank (NBP), Bank Al-Habib (BAHL) and Allied Bank (ABL) while United Bank (UBL), Bank Alfalah (BAFL) and Bank of Punjab (BoP) witnessed a decline in nine months profits in terms of growth.
The question arises, how did the banks earn profits in a low-interest-rate environment?
The question matters as lower interest rates tend to squeeze net interest margins. Given that, banks readjust their balance sheet activity from traditional lending business to earning assets, relying on income from stable funds such as fixed debt securities. Largely, the bond-portfolio investment decision of banks is based on present credit-market conditions, future interest-rate movements and demand for funds. The decision which treasuries invest to purchase and which to sell depends on portfolio size, risk exposure of realized and unrealized capital losses and other restrictions on the composition of the portfolio.
Falling interest rates have sent bank stocks plummeting, but there is a brighter side to this kind of move as banks reportedly registered capital gains of Rs 92.23 billion on government securities such as treasury bills (T-Bills) and Pakistan Investment Bonds (PIBs), listed shares along with federal government securities during 9MCY20.
The data released by the State Bank of Pakistan (SBP) shed some light on deposit –credit gap. Despite the low-interest rate, the total deposits held by commercial banks reached Rs 16.8 trillion by the end of September 2020, depicting a growth of 20% YoY while total advances were struggling at Rs.8.09 trillion. Consequently, the advances to deposits ratio (ADR) dropped to 48% in Sept’20 from 57% in Sept’19. This has widened the gap between deposit and advances growth rate.
This gap is being filled by the investment by banks in government securities. The banks (our sample of eight banks) invested about 90% of funds in government debt securities, shares and other federal govt. securities. Besides, the lower appetite for private sector credit due to the slowdown in the domestic economy amid the COVID-19 pandemic also enabled banks to increase their dependence to deploy in treasury securities.
Meanwhile, fresh deposits which were utilized in expanding the Investment portfolio grew by 20%YoY to Rs 11 trillion. Resultantly, banks’ investment to deposit ratio (IDR) was recorded at 66% in Sept’ 20.
Also, if banks don't invest in T-bills and PIBs when the opportunity arises, where on earth would they use this excess liquidity? This surplus might destroy the entire banking system which includes falling deposit rates, losses on bank balance sheets, lower savings, etc.
Keeping in mind the banks’ growth, a look at their balance sheets reveals that treasury profits have been earned by banks amid falling interest rates in two ways. First, the banks may have enjoyed higher yields on earlier investments made in PIBs and T-Bills that they have been piling over the years when the yield curve shifter the higher elevated level. The cut-off yields on fixed-term debt securities have followed the downward route of the policy rate, banks holding high yielding longer duration securities blow-up the gains on bonds portfolio as they keep on enjoying capital gains in a low-interest environment.
Looking closely at yield curve shift, in case a bank may have invested in 3-year PIBs issued on July 24, 2019, they may have booked capital gains. The cut-off yield on bond was 14.25%, the highest yield, while on bonds issued on July 07, 2020 was 7.37%. This translates that banks must have enjoyed 14.25% compared to the rate on the same period bonds issued in July 2020, which is around 8% as of now.
Considering another view, banks book capital gains by selling government securities in the secondary market to increase their earnings, ignoring the transaction costs or opportunity cost of investment. Amid falling rates across the debt markets, the prices of bonds which banks had purchased at the times of higher interest rates, rise, as a result, banks make hefty treasury gains. Since these govt debt securities are safe assets, there is little to no chance of an actual loss in case of shorter-term of the yield curve in declining rate environment as long as banks hold them till maturity, getting principal and return.
During 9MCY20, a pool of eight commercial banks cumulatively booked capital gains of Rs 92.23 billion on government securities such as treasury bills (T-Bills) and Pakistan Investment Bonds (PIBs), listed shares along with federal government securities. While capital gains on PIBs and T-Bills booked by banks were recorded at Rs 28 billion.
Interestingly, the investment breakup revealed that the capital gains on PIBs by scheduled banks have been higher than investment in T-Bills, standing at Rs 20.5 billion while those of treasury bills were Rs 8.3 billion only.
Among 8 banks, HBL realized the highest capital gains of Rs 18 billion during 9MCY20 and accounted for a 62% share in total treasury gains realized by the 8 conventional banks. Further, the capital gains booked by HBL in PIBs and T-Bills in total assets stood at 1%, attributing its substantial deployment of liquidity in government securities.
Apart from bond portfolios, banks realized capital gains from equity investments. It is pertinent to mention that the magnitude of surplus on listed shares clocked in at Rs 34 billion, which has been higher than capital gains on fixed return government papers, strengthening banks’ profitability.
Government-owned NBP carrying the highest surplus of Rs 19 billion on equities investments, contributing more than 50% towards the cumulative total gains on equities investments held by eight top tier commercial banks as of September 30, 2020. In addition, NBP’s surplus investment in Equity securities accounted for 7% of its book value, the highest among other banks in 9MCY20.
However, profits earned by banks from government debt securities are windfall and inconsistent in nature as per market analysts; while such gains may occur only once in five-six years economic cycle. Commercial banks keep awaiting for a reversal or shift in the SBP’s monetary policy, as an increase in the policy rate will increase cut-off yields on recently issued debt securities. On the flip side, a reversal in interest rates or an upward shift in the yield curve may result in a negative carry on long-term government papers. The question arises, how long the current wave of lower interest rates would prevail? Secondly, our corporate sector would be able to capitalize on the opportunity generated by the prevailing lower interest rate environment to expand and prosper in the long run. Ticking time may be able to answer these questions in the long run.
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