Moody’s Investors Service on Wednesday revised its outlook on Pakistan’s banking system from stable to positive, reflecting the sector’s resilient financial performance and gradual improvement in the country’s macroeconomic conditions.
In a statement, Moody’s said the positive outlook for the banking sector aligns with the Government of Pakistan’s outlook, as Pakistani banks maintain significant exposure to the sovereign through their substantial holdings of government securities. These securities account for approximately half of the total banking assets, it noted. However, it warned, Pakistan’s long-term debt sustainability remains at risk due to its still fragile fiscal position, high liquidity risks, and external vulnerabilities.
Economic Growth
Moody’s projects that the Pakistani economy will grow by 3% in 2025, up from 2.5% in 2024 and a contraction of -0.2% in 2023. It also estimates inflation to average out to around 8% in 2025 from an average of 23% in 2024.
According to the report, the problem loan formation will slow as borrowing costs and inflation decrease, through net interest margins will narrow due to interest rate cuts. Despite this, banks will maintain “adequate capital buffers, supported by subdued loan growth and solid cash generation, even as dividend payouts remaining high.”
Improved Conditions
Moody’s said Pakistan’s economic outlook is improving from very weak levels, with enhanced government liquidity and external positions compared to 2024. It cited the 37-month, $7 billion IMF Extended Fund Facility as a credible source of external financing for Pakistan over the next few years.
It noted that while profitability of banks would moderate with the decline in interest rates, it would remain sound. Pakistani banks derive a significant portion of their earnings from interest on large investments in government securities, which are yielding lower returns compared to last year due to rate cuts of the past year.
Moody’s Investors Service said downward asset repricing would only be partially offset by lower funding costs, and growth in business activity and non-interest income would not fully counterbalance margin compression. A potential deterioration in the loan book could increase provisioning costs from current low levels, while lower inflation would ease operating cost pressures.
The recent removal of the advance-to-deposit ratio tax, it said, would be offset by an increase in the corporate tax rate to 44% from 39%. Moody’s anticipates that banks’ return on assets will moderate to around 0.9-1.0% in 2025.
Capital Stability
Strong profitability, coupled with low credit growth in 2023 and 2024, has bolstered Pakistani banks’ capital buffers, said Moody’s. The Tier 1 Capital and total capital to risk-weighted assets ratios for the system improved to 17% and 21.5%, respectively, as of September 2024, up from 16% and 19.7% at the end of 2023. However, Moody’s tangible common equity to adjusted risk-weighted assets ratio remains low at 4.1%.
Problem loans are covered by loan loss reserves, with rated banks maintaining a coverage ratio of 112%, providing additional capital protection. Despite expected margin compression, Moody’s expects capitalization to remain broadly stable over the next 12 to 18 months, supported by modest growth in risk-weighted assets.
Funding and Liquidity
Enhanced financial inclusion and remittances from non-resident Pakistanis continue to drive domestic deposit inflows, which fund bank lending. Customer deposits remain the primary source of bank funding, accounting for 60% of total assets as of September 2024.
Although the market funding to tangible assets ratio is elevated at 41.9% as of September 2024, this primarily consists of short-term interbank funds and collateralized borrowing from the State Bank of Pakistan to invest in government securities.
Banks’ reliance on market funding is limited, with a system ADR ratio of 36.3% in September 2024 (down from 50.4% in 2022), and they are expected to maintain sufficient liquid assets to meet any unexpected outflows.
However, Moody’s estimates that around 40% of banks’ holdings in government securities are encumbered, held as collateral with the central bank. Foreign exchange risks have diminished following an increase in the central bank’s reserves, supported by the unlocking of the IMF program.