Banks’ net profits are growing thanks to their disproportionally huge investment in high-yield government debt papers and the growing share of savings and current accounts in their deposit mix.

In the first nine months of 2014 (9MCY14), the after-tax profits of banks rose to Rs115bn, up 40pc from Rs82bn in the same period last year. During this period, their net investment grew 17pc year-on-year, whereas their net advances increased just 12.2pc; deposits were up 13.5pc.

A slightly slower growth in advances vis-à-vis deposits isn’t a big deal. But if advances grow slower than investment, and then this becomes a trend, then all is not well, particularly if the share of low-cost current and saving accounts (Casa) dominate banks’ deposit mix.

By June, 75pc of banks’ deposits were in current and saving accounts, and term deposits constituted less than 25pc of the total, according to State Bank statistics.

For the past several years, banks’ profitability has originated chiefly from their investments — the bulk of which are in high-yield, risk-free government debt papers. And as they keep mobilising more Casa and less term deposits, the low cost of deposits helps in maintaining the growth in profits.

Declining inflation will surely further boost these trends, as it will increase banks’ real returns on investment and advances. The 50bps cut in the SBP policy rate in mid-November will automatically lead to a lowering of banks’ minimum deposit rate (MDR) — which is tied to the central bank’s repo rate — effectively reducing the cost of the bulk of deposits.

Given the reduction in yields on T-Bills and PIBs, “the only viable course for banks seems to be a gradual increase in fresh lending. If they don’t do that, growth in the next calendar year will be lesser than this year”

But the fall in the yields on Treasury Bills (TBs) and Pakistan Investment Bonds (PIBs) doesn’t mean an immediate reduction in banks’ return on advances even when these are tied with the yields on government debt. This is because the private sector begins retiring old expensive loans once it foresees that monetary easing is on the cards. And analysts have started predicting a further cut in the policy rate.

In such a case, banks continue to receive a high return on their old advances. This is currently the case because the private sector is retiring previous loans faster than it is seeking fresh ones.

And when banks make new loans, the impact of whatever reduction in the effective interest rate is lesser than the benefit they get through the decline in the MDR, simply because, numerically, fresh loans constitute a very small percentage of their Casa deposits.

Over the last six years, banks’ investments have been growing rapidly on the back of high government borrowing through TBs and PIBs. The stock of banks’ net investment has grown four-fold, from Rs1.087trn in CY08 to Rs4.313trn in CY13. But during this period, their net advances rose by just 29.5pc, from Rs3.173trn to Rs4.11trn. As a result, their advances-to-deposit ratio fell from 75.2pc to 49.5pc. Quite understandably, net profits steadily rose from Rs43bn in CY08 to Rs112bn in CY13.

With 9MCY14 profits at Rs115bn and with underlying contributors to profitability almost intact, full CY14 profits might be somewhere between Rs140-150bn, senior bankers say.

In 9MCY14, the five big banks reported sizable post-tax profits, with HBL (Rs20.5bn) in the lead, followed by MCB (Rs18.1bn), UBL (Rs15.8bn), NBP (Rs12bn) and ABL (Rs11.6bn). With a net profit of around Rs3.6bn, Meezan Bank maintained its profitability lead among Islamic banks. Among mid-sized banks, Standard Chartered Bank Pakistan topped with a net profit of Rs7.4bn.

But the high-profit stories of the banking sector as a whole has come at a huge cost. For years, banks have not come close to meeting the private sector’s credit requirements. “Because of the ‘crowding out’ phenomenon, growth in industrial and agricultural sectors have been hit,” opines a former deputy SBP governor, pressing the need for the central bank to push banks for faster lending.

Now, with the CPI down to an average 6.45pc in July-November FY15 against 8.84pc in the same period a year-ago, further policy rate cuts are expected.

The key question is, if monetary easing sets in, will banks be able to maintain their profitability ride? Backed by strong foreign exchange flows, increase in non-tax revenue and higher inflows into National Savings Schemes, the government’s need for bank borrowings may remain subdued next year. So, banks might not be able to earn as much fresh income from their investment in government debt papers as they did this year.

“Naturally, then, the only viable course for banks seems to be a gradual but volume-wise increase in fresh lending. If they don’t do that, growth in the next calendar year will be lesser than this year,” fears the head of a local private bank.

Published in Dawn, Economic & Business, December 8th , 2014