Moody’s revises Pakistan’s banking system outlook to positive

Moody’s Investors Service has revised its outlook on Pakistan's banking system from stable to positive, reflecting the sector’s resilient financial performance and the gradual improvement in macroeconomic conditions from very weak levels a year ago.

The positive outlook for the banking sector aligns with the Government of Pakistan’s (Caa2 positive) 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.

However, Pakistan's long-term debt sustainability remains a key risk due to its still fragile fiscal position, high liquidity risks, and external vulnerabilities.

Economic Growth and Inflation Trends

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. Inflation is also expected to ease significantly, with Moody’s estimating it to decline to around 8% in 2025 from an average of 23% in 2024.

The report highlights that problem loan formation will slow as borrowing costs and inflation decrease, although net interest margins are expected to narrow due to interest rate cuts. Despite this, banks are anticipated to maintain adequate capital buffers, supported by subdued loan growth and solid cash generation, even as dividend payouts remain high.

Improved Operating Conditions

Pakistan’s economic outlook is improving from very weak levels, with enhanced government liquidity and external positions compared to 2024. The approval of a 37-month, $7 billion IMF Extended Fund Facility in September 2024 provides a credible source of external financing for Pakistan over the next few years.

Moody’s forecasts GDP growth of 3% in 2025 and 4% in 2026, up from 2.5% in 2024. This growth is expected to be driven by a 10 percentage point reduction in interest rates since the start of the monetary policy easing cycle in June 2024.

Profitability and Margins

While profitability is expected to moderate as interest rates decline, it will remain sound. Margins are likely to narrow following recent interest rate cuts, which have reduced the policy rate to 12%. 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.

Downward asset repricing will only be partially offset by lower funding costs, and growth in business activity and non-interest income will not fully counterbalance margin compression. A potential deterioration in the loan book could increase provisioning costs from current low levels, while lower inflation will ease operating cost pressures.

The recent removal of the ADR tax is expected to 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 and Loan Coverage

Strong profitability, coupled with low credit growth in 2023 and 2024, has bolstered Pakistani banks' capital buffers. The Tier 1 Capital and total capital to risk-weighted assets (RWAs) 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 RWAs ratio remains low at 4.1%.

Problem loans are fully 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 RWAs.

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 (SBP) 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 (FX) risks have diminished following an increase in the SBP's FX reserves, supported by the unlocking of the IMF program.