Commercial banks are on a lending spree—not due to excess liquidity or a dramatic economic turnaround, but because of a regulatory issue. The government is imposing higher taxes on banks with lower Advance to Deposit Ratios (ADR), and nearly every bank falls short of the target and is looking to lend wherever possible.

Based on informal discussions with bankers, many of these loans are for non-productive uses, which could have unintended implications for the current account deficit, potentially leading to higher imports. Even if this doesn’t happen, the intended goal of increasing productive lending to the private sector remains unfulfilled.

In a recent development, the Islamabad High Court has barred the FBR from collecting income tax from a commercial bank based on low ADR. Askari Bank obtained a stay earlier this week, arguing that it’s beyond the FBR’s mandate to dictate how banks deploy their deposits. Simply put, how can the FBR impose income tax on a balance sheet item?

Nonetheless, the ADR tax is creating market distortions. Many banks are lending to Development Finance Institutions (DFIs) at below-market rates, and DFIs, which rarely engage in long-term financing, are then investing in T-bills and PIBs, earning a spread of 2-4 percent. This allows banks to avoid the ADR tax while the government’s borrowing continues unabated, with the spread effectively transferring from banks to DFIs.

Similarly, banks are lending at significant discounts to public sector entities. While there is high tax on direct government lending, quasi-government organizations are benefiting from these favorable rates.

In other cases, banks are increasing lending in foreign currency deposits through FE25 loans. This is reflected in a $525 million decrease in banking FX reserves over five weeks, likely due to a rise in FX loans. The interest rate on FX loans is around 5 percent in USD, compared to 13 percent for PKR loans. Many importers and exporters are betting on a stable PKR in the coming months, making FX loans more attractive. This is mutually beneficial for banks and borrowers but may lead to higher imports, straining FX liquidity.

In the auto sector, car companies are partnering with banks to offer auto financing at below-market rates. One company has launched a product, another is preparing to do so, and more are expected to follow. Meanwhile, the SBP has set an Rs3 million limit and a 36-month cap on auto financing to curb non-essential imports. However, the ADR policy may undermine the SBP’s intent to control auto imports.