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.

Indicators of Profitability of Banking Company

A typical banking company is engaged in financial intermediation, maintaining liquidity and payment systems in the economy, asset management and advisory services and forex and trade finance operations, etc. In particular a deposit taking financial institutions is likely to be highly leveraged due to the nature of financial systems in capitalist market economies such as the existence of fractional banking systems. Within the context of fractional banking system, deposits create loans, however, the ability to extend loans and credit is limited by the economic and regulatory capital of the banking company.

Generally a deposit taking bank is highly leveraged ranging from a 5 to 15 times that of economic capital. The bank tries to profit from the interest spread between the interest rates that are paid to depositors which is the cost associated with the deposits and the interest earned on loan portfolio and investment portfolio. In addition to spread income, the bank also receives income from fee based services such asset management activities, corporate banking, trade financing and facilitations, etc. So it is evident that the key indicator of performance is the level of leverage the banking company attains as compared to its economic capital. The spread income has low risk as the bankers able to diversify its loans portfolio and generally invest in highly liquid investment instruments.

The return on equity may be a starting point in the analysis of profitability of a banking company. However, due to the nature of banking business the ROE may be unstable and poor indicator of performance. The equity component of a banking company could be highly unstable due to frequent changes in the market value of banks assets including its investment and loan portfolio. In fact the loan portfolio may not have market value at all and the credit risk inherent in loan portfolio may not be properly priced. Therefore the performance of a banking company must include an assessment of market risk in its investment portfolio and the credit risk in its loan portfolio.

In addition to the market risk and credit risk, the operational risk should be accounted. The administrative expense is an important indicator of a bank's financial performance as the bank must earn enough income from its core banking activities to meet its administrative expenses. If a bank is unable to derive enough spread income to pay for the administrative expenses, the bank is likely to incur losses and it is failing to meet its social function of financial intermediation. In the analysis of the valuation of a banking company, the valuation using option theory could be beneficial.