The state bank of pakistan reduced its policy rate: the effect on the banking system and banks profitability

State Bank of Pakistan has reduced its policy rates to 12% which was 13.5% earlier. The policy or the discount rate is the rate of interest charged by state bank of Pakistan to supply reserve currency to its scheduled/commercial banks. Usually the bank borrows from interbank money market for meeting their short term cash requirements, nevertheless, the commercial banks move to central banks when the interbank money market is tight. The decline in the policy rate cannot be described as switch in the interest rate regime due to fears of inflation.

The effect of policy rates on the profitability of the banking system depends on the performance of the business sector. If reduced interest rates lowers credit risk, and spur economic activities both business and investing, and reduces business uncertainties, then the bank’s profitability will increase otherwise the bankers profitability will be reduced.

  

The banks make profit by taking credit, market, and operational risks. The policy rate will affect both market risk and credit risk in the economy; however, it is not the sole determinant of these risks. Other factors such as business condition, political and economic conditions, have much greater effect on these risk factors. Recently the banks have taken a greater exposure to government securities and therefore their revenue is likely to fall. The banks will shift some of their assets from government securities to loans or credit portfolio.

The lower interest rate is less likely to reduce the interest rate spread income for the banks. The lower interest rate will also increase the overall deposits of the banking system and will likely to increase both investment and loan activity of the banks. Those banks with healthy equity capital are more likely to make profit from expanding economic activity.