ISLAMABAD: Moody’s Ratings on Monday changed Pakistan’s banking system’s outlook to stable from positive as operating conditions continue to recover ‘only gradually’.

“The operating environment continues to recover, but only gradually, supported by the country’s slowly improving economic and fiscal outlook, and strengthening external position”, the New York-based one of the top three global rating agencies said. “However, banks’ financial performance will be stable over the next 12-18 months as they continue to face asset quality and profitability challenges,” it added.

The bank sector outlook aligns with that of the Government of Pakistan (Caa1 stable), given banks’ substantial holdings of government securities, which account for around half of total banking assets.

“Pakistan’s long-term debt sustainability remains uncertain, because of its still weak fiscal position, high liquidity and external vulnerability risk”, the agency said and estimated real GDP growth of around 3.5pc for 2026, up from 3.1pc in 2025, supported by ongoing reforms that are improving confidence and gradually strengthening economic activity.

Moody’s flags high exposure to govt securities as a key risk

The improving economic outlook and lower inflation have contributed to easing monetary policy rates. Lower borrowing costs will boost credit demand and keep problem loan ratios broadly unchanged. At the same time, margins will remain steady after a decline following rate cuts, but higher business volumes, non-interest income and stable costs will support profits and safeguard capital buffers.

It was observed that last year’s floods could weigh on agricultural output, but activity in the industrial and services sectors should remain robust. The improving economic outlook and lower inflation have contributed to easing monetary policy rates. “We expect inflation to rise to around 7.5pc in 2026, in part due to base effects”, it said.

Moody’s highlighted banks’ high exposure to government securities as a key risk. Exposure to government securities amounts to around half of banks’ total assets and around 9.4 times their equity, which links their credit strength to that of the Caa1-rated sovereign.

It noted that sector-wide nonperforming loan ratios spiked at the beginning of 2025 following the removal of the advances-to-deposits ratio (ADR) tax, prompting banks to reduce their loan books. Although loans accounted for only 23pc of banks’ total assets as of September 2025, there could be double-digit credit growth in 2026, supported by improving macroeconomic conditions. Borrower delinquencies will persist nonetheless, particularly in more vulnerable sectors such as agriculture and energy, but lower borrowing costs and higher credit demand will maintain broadly stable problem loan ratios.

Although financing growth will rise in 2026 on the back of lower rates, Pakistani banks will continue to increase their holdings of government securities, which do not carry any risk-weighting, further supporting capital metrics. “We expect banks to maintain high dividend payout ratios, but retained earnings — despite slight margin compression — will be sufficient to fund balance sheet growth and maintain capital ratios”, it said, adding that problem loans were fully covered by loan loss reserves, providing additional capital protection.

Lending volumes and non-interest income will offset margin squeeze, Moody’s said and expected Pakistani banks to deliver an average return on assets of around 1.1pc in 2026. Banks will exhibit modest margin compression as the pace of rate cuts slows, while funding costs remain broadly stable, following the removal of the regulatory minimum deposit rate (MDR) previously applied to corporate and institutional deposits.

However, higher business activity and lending volumes, coupled with non-interest income, will balance tighter margins and preserve banks’ operating revenue. A potential deterioration in the loan book would push loan-loss provisioning costs up from low levels, while lower inflation will reduce the strain on operating costs. Elevated taxes will continue to weigh on bottom-line profitability. Funding and liquidity will remain sound.

Pakistani banks are predominantly deposit-funded, with customer deposits accounting for 63pc of total assets as of September 2025, supported by financial inclusion initiatives, strong remittance inflows from non-residents as well as digitalisation efforts. However, competition for low-cost deposits has increased within the system, which has resulted in a rise in banks’ funding costs and migration to savings and time deposits. Positively, banks exhibit limited reliance on market funding, with net loans representing 35.6pc of customer deposits and less-stable funds accounting for 30.6pc of tangible banking assets as of September 2025.

Published in Dawn, February 10th, 2026