Karachi, October 31, 2022 (PPI-OT): Would Islamic Banking be brought back to minimum profit rates?

With inclusion of Islamic Banks in the Interest Rate Corridor (IRC) in late 2021, the next development that may follow could be the implementation of minimum Profit / Deposits Rates (MDR), which is currently exempted for said segment since 2012.

We discuss implications of the same on MEBL and FABL in today’s note. While the prospective development may cut MEBL’s earnings by 28% in a worst-case scenario, impact on FABL may be limited as it already offers relatively higher deposit rates.

While the earnings risk to MEBL looks significant on a ceteris paribus basis, we highlight that the volumetric gains from offering higher rates might offset most if not all of the drag on profitability and maintain our Overweight stance on the stock.

Our base case estimates maintain deposit costs around current levels offered by FABL and do not incorporate any change due to the conversion. The recent excitement around the stock (+32% FYTD vs index) could however sustain over expectations of higher demand from options-starved Shariah investors and sustained higher dividend payout post conversion.

Regulatory developments in Islamic Banking

In a move to improve management of market liquidity, the State Bank of Pakistan (SBP) had introduced Shariah compliant OMO Injection and Standing Ceiling Facility for Islamic Banking in Pakistan in the later part of 2021. With inclusion of Islamic Banks in the Interest Rate Corridor (IRC), the next development that may follow for Islamic Banks could be the implementation of minimum profit rates / Minimum Deposits Rates (MDR), which is currently exempted for the said segment.

The MDR is charged at 150bps below the Policy Rate for conventional banks, which means the MDR, which is applicable on all categories of savings/ PLS saving deposits (including any other profit bearing deposit with no fixed maturity), is currently at 13.50%.

If the same is applicable for Islamic Banks, this would not be a new phenomenon. To recall, SBP introduced the concept of minimum profit rates on the eligible savings accounts mentioned above in May-2008 on Pakistan Banking sector, including Islamic Banking. The Islamic Banking was later excluded from the instruction in Nov-2012.

What is the current status?

Islamic banks are currently offering savings rates at ~300-700bps lower than conventional banks’ MDR. These rates are not subjected to any regulation and are set by respective Islamic Banks on their own. This means any regulation of a similar MDR on the Islamic Banking industry on a standalone basis could have a significant negative impact on their prospective ROE.

Though industry sources suggest mixed reports regarding discussions over the subject with central bank, we believe Islamic Banking industry, as a whole, is still not on a level-playing field with conventional banks until introduction of shorter tenor Shariah government securities and consistency in Shariah government securities auctions.

MEBL has the potential to narrow the augmented impact

At ceteris paribus, an MDR regulation similar to the conventional banks would slash our earnings estimates for Meezan Bank (MEBL) by 15% in the current interest rate environment, while impact magnifies to 26% in a scenario where Policy Rate would go down to 10%. As a result, our recurring Tier I ROE would fall from 34% to 30% where long-term interest rates are 10%. Savings deposits currently account for the bank’s 36% deposits. We present a sensitivity of various scenarios where the minimum rate may start from a lower flat rate, gradually being linked to the IRC.

We, however, put weight on two key moving parts in this set-up; (1) the Shariah- conscious market segment MEBL currently caters to, evident from its expanding mix of zero-cost deposits in the pie over the years, and (2) the growth potential MEBL’s deposits would unlock when offering similar deposit returns as peers, inviting the other side of the market segment.

Given the ongoing focus on maintaining a higher ADR in order to avoid additional taxes, we expect MEBL to continue to keep deposit growth in mid-teens by targeting optimal zero-cost deposits, as compared to 21% CAGR it has recorded in the last 5 years (sector: 13%). Nonetheless, once the management feels bank’s Gross ADR is at comfortable levels (Sep-2022: 53%) we do not rule out possibility of MEBL shifting its strategy back to higher deposit growth, fuelling its ROE at a faster pace.

FABL: Newcomer to Islamic league may see lower impact

Faysal Bank (FABL) carries almost 40% of savings deposits from the total pie and because FABL has been a conventional bank to date, it has been subject to the MDR regulation. Since it has been under transition to convert itself into a full-fledged Islamic Bank, it has used relatively attractive deposit rates as compared to Islamic Banking to sustain relationships with existing deposit holders. Hence, we believe any implementation of MDR on Islamic Banking is likely to bear limited impact on FABL’s base case bottom-line once it turns into an Islamic Bank. For perspective, given the larger contribution from savings deposits, FABL’s current cost of total deposits, (excluding zero-cost deposits) is ~120bp above the cost reported by average listed Islamic Banks.

Overweight stance intact on MEBL and FABL

We reiterate Buy on MEBL and FABL. Both stocks have outperformed the market by 8% and 32%, respectively in the ongoing fiscal year, and we expect the outperformance to continue given their respective value plays.

We believe MEBL stores immense potential to counter the negative impact from the prospective development, limiting long-term ROE impact from the worst-case scenario. We, however, do not rule out pressure in the short-term, if/when any development of this nature is announced.

FABL is set to become among the only three bets from the banking space obtainable by Shariah investors beyond CY22. The conversion timeline is set for 2HCY22, while we do not rule out an earlier date. This can lead to re-rating over higher demand from Shariah based investors, in addition to possibility of recurring ~16% – 18% D/Y on cards. Our base case estimates do not incorporate a lower deposit rate and keeps pay-out ratio at 30% till clarity on strategy from management.