Meezan Bank: What Would Happen if a Floor Rate is Imposed on Islamic Bank Savings?

Meezan Bank has rallied from a one-year low of Rs 82.96 to Rs 98.43 (as of 9th July). That implies a gain of 19%. In that same period of three weeks, the KSE100 has gained 10% from its low. This comes as no surprise given that Meezan Bank has become a favorite momentum stock (in the banking sector) for both retail and institutional investors – replacing the once-mighty HBL.

But with this rise of Meezan, many have questioned: what if a floor rate were to be imposed on deposit accounts in Islamic banks? Before answering this, a bit of context is needed.

The banking sector is a heavily regulated sector in Pakistan. The State Bank of Pakistan (SBP) decides who gets to own banks, how many banks can exist and how those banks can operate to a large extent. SBP controls how many banks can set up shop in Pakistan by issuing limited banking licenses.

By issuing few banking licenses, the banking license for a bank becomes a crucial and valuable asset similar to the old taxi medallions in NYC. This is why seemingly insolvent banks like Summit Bank continue to receive buyer interest. But this barrier to entry comes with the cost of low competition in the banking sector.

Now to solve this complication initially caused by over-regulation, SBP sets a floor interest rate on non-current account deposits of conventional banks. Currently, the floor rate is a minimum of 1.5% below the SBP target rate, leaving banks with a minimum spread of 1.5%.

Interestingly, this floor rate does not apply to Islamic banks as the government and SBP both want to promote Islamic banking in the country. You can consider it to be a part of their plan to boost Islamic banking in the country.

Now, if the government were to impose a similar floor rate for Islamic banking, that would certainly result in reduced profitability. For instance, a leader among conventional banks, Alfalah Bank has a cost of deposits of 9.2% compared to Meezan Bank’s cost of deposits of 6.7%. If Meezan’s cost of deposits were to go up, that would certainly chew off their spread and eat into their profitability.

But how much would Meezan Bank’s shareholders suffer? To calculate this, we can do a comparative analysis of cost of deposits. If a floor rate was imposed on Islamic bank savings, then we can expect Meezan’s cost of deposits to converge to that of conventional banks (provided SBP puts the same floor rate for both Islamic and conventional bank savings).

Now, Meezan’s cost of deposits stands at 6.7% while the cost of deposits for the major conventional-heavy banks is 8.6%. If Meezan’s cost of deposits were to rise to 8.6%, its interest expensed would increase by Rs 30 billion. Profit before tax be trimmed to Rs 58.9 bn.

Applying an effective tax rate of 45% on bank income would give us an after-tax profit of 32.4 bn. That would put Meezan Bank just ahead of UBL in profit-after tax rankings (UBL is currently the fourth most profitable bank). However, Meezan would still be the most profitable bank with respect to deposits. Note that HBL made a profit of Rs 34 bn last year and has over Rs 3.4 trillion in deposits (largest bank) compared to Meezan’s 1.7 trillion in deposits.

So even if a floor rate is imposed, Meezan’s profitability will remain intact even though it would create a temporary shock. How is this possible? Well, Meezan Bank is a leader in consumer finance which allows it to lend out cash at higher rates than conventional banks which park most of their money in T-bills and bonds. This is a result of necessity as the Government of Pakistan doesn’t issue many Islamic securities. Consequently, Islamic capital markets aren’t as deep as conventional capital markets.

This translates into Meezan having a superior return on assets (second highest ROA among banks). In addition to this, among the analysis of cost of deposits, it is essential to note that Meezan also has an above-average CASA ratio. This means that it has a higher percentage of zero- or low-interest deposits which pay little interest and minimize its cost of deposits. Both of these are a massive competitive advantage for Meezan Bank.

So now that we’ve established the impact on Meezan’s profitability, where would Meezan’s share price go and what dividend would it offer? Meezan is currently trading at a trailing PE of 3.96, a trailing dividend yield of 9.8% and a payout ratio of 39%.

Assuming that PE ratio remains the same, its share price would fall to Rs 71 (currently Rs 99) meaning it would hit the lower lock in four consecutive trading days. Meezan Bank would still trade at a premium to its book value. Meanwhile, assuming that its payout ratio remains the same, it would offer a dividend of Rs 12.6 per share which would impute a dividend yield of 17.7%.

However, we are assuming a trailing PE ratio of 3.96 when in fact, banks have historically traded at PE of 7-8. Moreover, the key assumption in this analysis is that Meezan’s cost of deposits would converge to the 8.6% cost of deposits for conventional-heavy banks. It could very well be the case that cost of deposits remain lower than this.

Despite having done this analysis, one has to take a step back and ask: what are the chances the government would impose such a floor rate on Islamic savings? That’s the real question. And my very real hunch is: very low. But of course, things can change quickly. Even more so in a nation as volatile as Pakistan.

*Note: all figures are from CY2022 Financial Results*