It goes without saying that a cut in the interest rate by the State Bank of Pakistan has sparked quite some debate in the financial industry. While low rates are anticipated to witness ebullience in economic activities, it is risky, particularly relating to the mismatch between assets and liabilities.

Regarding interest rate risk, this inconsistency could be between the interest sensitivity of assets, which are loans, and liabilities which consist of deposits, facing the banks. The problem worsens in a declining rate environment, where funding cost reductions compress the net interest margins and adversely affect profitability.

Thus, where banks have huge fixed-rate loan portfolios such as HBL, UBL, and MCB, lower interest rates slow the asset yield decline but reduce funding costs. This wrong mismatch can endanger core profitability in a fragile economy where reckless borrowing brings a higher probability of loan defaults. Economic uncertainty and weak customer confidence further reduce demand for loans, thereby reducing the desired stimulus impact.

The strategies employed by banks in managing risk should tend to make the maturity and rate sensitivity of assets and liabilities more similar. Changes in rates can have an adverse effect, which can be mitigated through compensatory instruments like interest rate swaps and futures. Diversification of loan portfolios and pricing loans and deposits in accordance with rate trends may sustain revenue.

While deposits are hardly sensitive to interest rates, their management has very high operational costs, among them, investments in IT and branch infrastructure. These deposits play a crucial role in maintaining liquidity and absorbing economic shocks.

However, factors such as inflation and external debt are weakening the effects of lower interest rates on Pakistan’s economy. Policymakers should therefore end rate cuts for another year while concentrating on stabilizing inflation, enhancing reserves in foreign exchange, and addressing structural inefficiencies in the economy.

Talib Noorani (Karachi)

Copyright Business Recorder, 2024