Resilience of the Banking Sector 4

The stress scenario used in this assessment is not a forecast of macroeconomic and financial conditions. It is a
hypothetical, coherent, tail-risk setting designed specifically to assess the resilience of the banking sector against
hypothesized deterioration in macroeconomic conditions. Under both the baseline and stress scenarios, the
solvency level of the banking sector comes under strain but remains well above the domestic regulatory
benchmark over the projected three-year horizon. Systemically important large banks carry sufficiently higher
capital buffers and are expected to sustain the impact of the assumed shocks over the assessment period.
Similarly, the medium and small sized banks are also expected to remain resilient to the shocks. However, credit
growth under the baseline scenario is projected to remain low but positive. Under the stress scenario, loans
growth is projected to be lower –entering even in negative growth territory. Considering the uncertainty
regarding global commodity markets and macro financial conditions, the SBP continues to closely watch the
evolving situation and remains ready to take actions necessary to safeguard financial stability.
4.1 Overview and Scenario
4 Resilience of the Banking Sector
Design premium and economic agents’ sentiments led
to a challenging macroeconomic environment
In order to gauge the resilience of regulated during first half of CY23. Driving factors behind
entities, SBP conducts a series of periodic stress these shocks included heightened level of
tests1 on a regular basis, including a yearly political uncertainty and disruptions in the IMF
comprehensive top-down Macro Stress Testing2 stabilization program at a time when foreign
(MST) exercise for the external stakeholders. The exchange (FX) reserves were at a low position.
MST exercise involves mapping the impact of Lagged impact of floods in Q3CY22 and
credit, market and operational risks, under insufficient fiscal consolidation also played their
baseline and stressed scenarios, on banks’ role in pushing inflation up.3 As a result of these
solvency position. The projection horizon for the challenges, domestic economy faced historically
MST exercise is three years. high levels of inflation and currency
depreciation, coupled with a sharp reduction in
The MST exercise incorporates two hypothetical real GDP growth.4
scenarios, namely, baseline or business as usual
(S0) and stressed (S1). The horizon spans Q1CY24 However, macroeconomic environment
to Q4CY26. A dynamic balance sheet is improved in second half of CY23. Positive
assumed, where advances and their delinquency developments in external sector included
rates are estimated based on dynamics of macro- resumption of the IMF program, considerable
financial risk factors under the assumed reduction in country risk premium, surplus in
scenarios. Whereas for the solvency, the current account on annual basis, improvement
projected paths of lending portfolio and non- in FX reserves and stability in exchange rate. On
performing loans (NPLs) are used to estimate real side, developments included improvement
the regulatory capital (RC) and risk weighted in business confidence, signs of recovery in
assets (RWA). Specifically, the RC and RWAs large-scale manufacturing and reduction in
are impacted by the credit, market and inflation. Against this backdrop, the baseline
operational risks. Projections are obtained using scenario, S0, is built around three main
a suite of vector auto-regressive (VAR) models. assumptions regarding global and domestic risk
factors.
In addition to the system level assessment, the
cross-sectional heterogeneity is also captured for The new government will be able to unlock
the different segments of the banking industry multilateral financing and implement economic
in terms of size, i.e., small, medium, and large reforms in a stable policy environment…
banks.
First, S0 assumes that the formation of new
4.2 The Baseline Scenario (S0) coalition government will bring about stability
to ensure continuity of multilateral financing
The confluence of long standing structural under a new IMF program, which is in part
weaknesses with shocks to country risk contingent upon implementation of economic
reforms in fiscal, energy and state-owned-

1 SBP applies various approaches i.e. top-down & bottom-up; methodologies i.e. sensitivity & macro stress tests, and; a suit of
models. Currently, SBP follows stress testing regime established under Stress Testing Guidelines of FSD Circular No. 01 of 2020.
2 MST is considered an important risk analysis tool as it evaluates the shock absorption capacity of financial institutions towards

adverse macroeconomic developments in a forward-looking manner.

3 A brief account of global and domestic developments during CY23 has been covered in Chapter-1.
4 Real GDP growth declined from 6.2 percent in FY22 to -0.2 percent in FY23. YoY inflation and depreciation during CY23 were 29.7

and 19.7 percent, respectively.

Resilience of the Banking
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Financial Stability Review, 2023

enterprises sectors. Further, the presence of Two other factors are also incorporated in the
domestic stability, together with availability of baseline scenario. First, given Pakistan’s
multilateral financing, will boost sentiments, vulnerability to global warming, climate risk
stabilize domestic currency and pave the way related events of moderate scale may lead to
for gradual economic recovery. However, owing economic losses during the projection horizon.6
to fiscal discipline under assumed multilateral The scenario assumes that average level floods
funding arrangement and cautious monetary may impact economic activity to some extent,
policy stance amid ongoing inflationary while causing temporary bouts of food inflation.
environment, GDP growth is not likely to Second, global geo-economic fragmentation and
exhibit a sharp rebound. resulting slowdown in global trade and
productivity are likely to negatively affect
Public debt is expected to remain under check owing external inflows for the domestic economy.
to fiscal consolidation measures and stable exchange
rate… Consequently, growth is assumed to exhibit gradual
recovery while inflationary pressures are likely to
Second, the scenario assumes that owing to ease in a stable but consolidating policy
implementation of fiscal consolidation measures environment…
under the new IMF program, fiscal deficit will
be manageable. On the other hand, resumption In this perspective, S0 assumes GDP to grow by
of multilateral flows is likely to boost around 2.5 percent in FY24 and 2.8 percent in
confidence, reduce risk premium and stabilize FY25. However, the growth is expected to rise to
the exchange rate. Based on these two 4.0 percent in FY26 on account of the assumed
assumptions, the public debt, which increased ameliorations in global and domestic economic
by 28.4 percent in CY23, is likely to remain in environment (Figure 4.1). Further, YoY average
check. However, to control rise in circular debt, CPI inflation may stay at elevated levels of 25.1
revisions in energy tariff and disbursement of percent and 12.8 percent during FY24 and FY25,
power subsidies under the Circular Debt respectively. Inflation is assumed to reach 7.0
Management Plan FY24, alongside other fiscal percent during FY26 (Figure 4.2).
measures, are assumed to put upward pressures
on prices. Real GDP Growth Figure 4.1
Actual Scenario 0 Scenario 1
Global commodity prices are expected to remain percent
7
broadly stable…
6
5
Finally, global food and energy prices, which
4
peaked in the aftermath of the Russia-Ukraine
conflict amidst post-pandemic recovery, have 3
leveled off after observing a substantial decline 2
in 2023. Following global projections and future 1
oil contracts, the scenarios assumes that oil 0
prices will remain stable in 2024 before -1
observing a slight decline in 2025. In case of
FY21

FY22

FY23

FY24

FY25

FY26

food, favorable supply conditions may lead to

around 5 percent reduction in global food price Source: SBP Staff Calculations
index.5

5World Bank Commodity Markets Outlook, April 2024.

6The Germanwatch has included Pakistan in the category of countries that are recurrently affected by the catastrophes and has
ranked it at 8th position in long-term climate risk index. Global Climate Risk Index (CRI) 2021. Germanwatch.

62
 Resilience of the Banking
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Resilience of The Banking Sector

Inflation Figure 4.2 of official bilateral, as well as private flows, may

Actual Scenario 0 Scenario 1 either become difficult or costlier.
40 percent
Climate-change related events of high severity pose a
35
major risk to macro economy…
30
25
Considering the recurring history of climate risk
20 related events, as discussed in the previous
15 section, S1 assumes that climate events of
10 extreme severity may lead to economic losses
5 during the projection horizon. A major climate
0 related event is assumed in the first year of the
projection horizon – e.g., recurrence of rains and
FY21

FY22

FY23

FY24

FY25

FY26 floods similar to CY22.

Source: SBP Staff Calculations
A rise in geopolitical tensions may result in
resurgence in global commodity prices…
4.3 The Hypothetical Stressed
Scenario (S1) S1 assumes continuation of geopolitical conflicts
in the Middle East and Eastern Europe that may
The S1 is built around the following assumptions push food and oil prices up and precipitate
regarding global and domestic risk factors. negative supply shocks for global food and
energy markets, culminating into a surge in
Domestic uncertainty may lead to lagging pace of global commodity prices. Resultantly, S1
economic reforms… assumes that the average oil prices may rise to
USD 98 per barrel by the end of FY24, before
Economic reforms are critical to address long- gradually declining to USD 83 per barrel by the
standing structural issues of fiscal sector, end of projection horizon.7
particularly pertaining to the energy sector and
state-owned enterprises. The S1 assumes that … leading to elevated inflation necessitating
owing to political cost, an inaction or resistance continuity of tight global financial conditions
may lead to a slow pace of reforms agenda.
Delays or disruptions in economic reforms may Global headline inflation indicators are showing
affect productivity of the economy in the long- declining trends and monetary policy rates in
term and stability in the short-term. advanced economics are likely to ease.
However, the assumed surge in commodity
…culminating into delays or disruptions in the prices together with inflation inertia, may lead
multilateral financing to elevated levels of inflation globally. This
situation may call for delays in anticipated
Assumed slowdown on economic reforms may interest rate cuts leading to realization of
adversely affect prospects of smooth inflows “higher-for-longer” scenario. S1, thus, assumes
from multilateral sources. Given the low level of that financial conditions may tighten in the near
FX buffers, this situation may push up risk term, making external financing for emerging
premium and exert pressure on exchange rate. markets and developing economies (EMDEs),
In the absence of multilateral flows, realization including Pakistan, more expensive and
difficult. This may also build pressure on

7Corresponding baseline assumptions are USD 82.4 per barrel at the end of FY24 and USD 70 per barrel at the end of projection
horizon.

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Financial Stability Review, 2023

EMDEs’ domestic currencies and may result in result, the GNPLR peaks at 12.3 percent from
flight to safety. current level of 7.6 percent before settling at 11.6
percent by the end of projection period CY26.
To sum up, the domestic economy may continue to
face the stagflation during the projection horizon… The asset quality indicator, under hypothetical
stressed scenario, S1, on the other hand, follows
Consequently, the real economy is assumed to an upward trajectory because of the assumed
grow by 0.4 percent and 0.8 percent in FY24 and
sharp slowdown amid elevated global
FY25, before resuming a growth level of 2.4
commodity prices and domestic supply shocks.
percent in FY26 (Figure 4.1). Under S1, the
adverse supply shocks are assumed to preclude The advances growth may also significantly be
normalization of ongoing domestic inflationary affected. Under S1, the lending portfolio is
trend. Accordingly, headline inflation in FY24 projected to contract, on average, by 2.3 percent
and FY25 is assumed to be 32.4 and 36.5 percent, over the projection period. The delinquency rate
respectively. Inflation is gradually assumed to peaks at 15.8 percent and remains elevated until
come down to 17.8 percent in FY26 (Figure 4.2). the end of projection horizon (Figure 4.3).

4.4 Stress Testing Results: System System-Level Gross Non-Performing

Loans Ratio
Figure 4.3

Level 17
Actual Scenario 0 Scenario 1
percent
16
15
a) Impact on Credit Riskiness
14
13
The results of the MST exercise indicate that the 12
gross non-performing loans ratio (GNPLR) 8, 11
under S0, is likely to remain on the higher side 10
9
over three-year projection horizon (Figure 4.3).
8
The rise in loan delinquency ratio, despite 7
assumption of gradual recovery, may be
Sep-21

Sep-22

Sep-23

Sep-24

Sep-25

Sep-26
Mar-21

Mar-22

Mar-23

Mar-24

Mar-25

Mar-26
explained by two factors. First, advances are
projected to decline initially in response to a
Source: SBP Staff Calculations
sharp deceleration of GDP in recent past. This
denominator effect explains the rise in GNPLR.
b) Impact on Solvency
However, the advances’ growth becomes
positive in the second half of projection horizon;
The impact on solvency is measured via the
leading to slight reduction in baseline GNPLR
Capital Adequacy Ratio (CAR) of the banking
towards the end of projection horizon. On
system.9 The CAR of the system declines in both
average, advances are projected to grow by 3.0
the scenarios. Under the baseline, the CAR
percent over FY24 –FY26 under S0.
shrinks by 183 bps by the end of CY26 from the
prevailing level of 19.7 percent. However, in
Second, the lagged effects of economic
stress scenario, it falls by 303 bps from the
challenges of recent past e.g. slowdown in
current level (Figure 4.4).
economic activity, high inflation and high
interest rate may lead to surge in NPLs. As a

8 GNPLR = Gross Non-Performing Loans ÷ Gross Advances

9 CAR = Eligible Capital ÷ Risk Weighted Assets

64
 Resilience of the Banking
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Resilience of The Banking Sector

System-Level Capital Adequacy Ratio Figure 4.4

4.5 Results: Cross Sectional
Actual Scenario 0 Scenario 1
21 Dynamics of Banking Segments
percent
20
19 In line with the system-level credit risk analysis,
18
infection ratios of banking segments (small,
17
16 medium and large sized banks) 11 have also been
15 projected separately. This aspect of the banking
14 industry is included to assess how cross-
13 sectional heterogeneity affects the resilience of
12 Domestic CAR Benchmark
banks against various macroeconomic risks.
11
Sep-21

Sep-22

Sep-23

Sep-24

Sep-25

Sep-26
Mar-21

Mar-22

Mar-23

Mar-24

Mar-25

Mar-26 For the GNPLR, system-level projections of

NPLs and gross advances are distributed
Source: SBP Staff Calculations
proportionately based on the contribution of
Positively though, under both the scenarios, the
each segment to the aggregate loan portfolio of
banking industry maintains its CAR above the
the banking system as of December 2023.
local minimum regulatory requirement of 11.5
Similarly, capital is also distributed
percent and global benchmark of 10.5 percent
proportionately to compute segment level
during the entire period of projection horizon.
CARs.

The resilience of the banking sector, despite the

(a) Large Banks
substantial level of assumed slowdown in real
economy, can be justified based on following
The large banks segment - comprising 76.7
facts. First, the banking sector is already
percent of the banking sector’s assets – under S0
maintaining higher capital buffers i.e. 817 bps
witnesses an increase of 365 bps in GNPLR by
above the regulatory benchmark of 11.5 percent.
end-CY26 from its current level of 6.9 percent.
Second, the release of 100 bps capital
Under S1, however, the rise in infection ratio is a
conservation buffer during COVID-19 has not
bit sharper: 729 bps by the end of projection
been reversed yet, which gives banks additional
horizon (Figure 4.5). The CAR decreases by 183
liquidity. Third, favorable overall repricing gaps
bps in the baseline scenario and falls by 304 bps
amidst assumed policy rate movements provide
in the stressed scenario from prevailing level of
further cushion during times of stress. Finally,
19.7 percent over the projection horizon (Figure
the sector’s historical behavior has been to re-
4.6). Remarkably though, the CAR remains,
balance asset portfolio from riskier private
respectively, 641 bps and 520 bps higher than
sector loans to risk-free treasury investments.10
the local benchmark under S0 and S1.
Moreover, the banks in general follow a
conservative lending strategy and prefer to lend
to borrowers with better credit worthiness, as
well as capacity to withstand macroeconomic
shocks.

10 The share of credit to public sector relative to total assets of banks increased from 55.81 percent at the end of CY22 to 60.56 percent
at the end of CY23.
11 The categorization has been done based on balance sheet footing. The banks with assets above 70 th percentile of the entire banking

sector are termed as ‘Large’ while below 30th percentile are categorized as ‘Small’. The banks falling in between these two
thresholds are categorized as ‘Medium’ sized banks.

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Large Banks - Gross Non-Performing Figure 4.5 (b) Medium-sized Banks

Loans Ratio
Actual Scenario 0 Scenario 1
15 percent By the end of the projection period, the infection
14 ratio of medium-sized banks (having market
13 share 17.5 percent) increases by 501 bps and 999
12
bps in S0 and S1, respectively, from existing 9.5
11
10
percent (Figure 4.7). The CAR, correspondingly,
9 attains 166 bps and 276 bps lower level
8 compared with the prevailing reading of 17.9
7 percent, under S0 and S1. The medium-sized
6 banks are, therefore, also expected to remain
Mar-21

Mar-22

Mar-23

Mar-24

Mar-25

Mar-26
Sep-23

Sep-24

Sep-25
Sep-21

Sep-22

Sep-26
compliant with the regulatory CAR standards,
even under the stressed scenario (Figure 4.8).
Source: SBP Calculations
Medium Banks - Gross Non-Performing Figure 4.7
Loans Ratio
Large Banks - Capital Adequacy Ratio Figure 4.6 Actual Scenario 0 Scenario 1
22
Actual Scenario 0 Scenario 1 percent
21 20
percent
20 18
19
16
18
17 14
16 12
15 10
14
8
13
12 Domestic CAR Benchmark 6

Sep-26
Sep-21

Sep-22

Sep-23

Sep-24

Sep-25
Mar-21

Mar-22

Mar-23

Mar-24

Mar-25

Mar-26
11
Sep-21

Sep-22

Sep-23

Sep-24

Sep-25

Sep-26
Mar-22
Mar-21

Mar-23

Mar-24

Mar-25

Mar-26

Source: SBP Calculations

Source: SBP Calculations
Medium Banks - Capital Adequacy Ratio Figure 4.8

The large banks are generally well-placed to Actual Scenario 0 Scenario 1

19
withstand stress over the simulation horizon. percent
18
Higher capital buffers available with larger
17
banks are the likely factor behind this resilience.
16
Incidentally, these banks generally have
15
relatively lower costs of funds due to their wider
14
outreach, giving them a competitive advantage
to maintain a loan portfolio of relatively better 13

rated obligors. More importantly, the 12 Domestic CAR Benchmark

systemically important banks are also likely to 11
Sep-21

Sep-22

Sep-23

Sep-24

Sep-25

Sep-26
Mar-21

Mar-22

Mar-23

Mar-24

Mar-25

Mar-26

remain well-capitalized and resilient to the

shocks assumed in stressed scenario.
Source: SBP Calculations

66
 Resilience of the Banking
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Resilience of The Banking Sector

Their level of CAR remains 476 bps and 367 bps Small Banks - Capital Adequacy Ratio Figure 4.10
percentage points above the minimum Actual Scenario 0 Scenario 1
27
regulatory requirement (11.5 percent) in S0 and percent
25
S1, respectively. Although their delinquency
23
ratios are higher and pre-shock capital buffers
21
are lower than the large and small banks
segments, however, medium-sized banks also 19

carry sufficient capital buffers and can 17

withstand assumed shocks under stressed 15

scenario. 13 Domestic CAR Benchmark

11

Sep-21

Sep-22

Sep-23

Sep-24

Sep-25

Sep-26
Mar-22
Mar-21

Mar-23

Mar-24

Mar-25

Mar-26
(c) Small Banks

Small banks – contributing 5.7 percent of the Source: SBP Calculations

banking sector assets – are also found to be
resilient against both baseline and stressed Overall, under the baseline scenario, although
scenarios. From its existing level of 9.3 percent, the delinquency ratio rises, the solvency of the
the loan delinquency rate increases by 487 bps in banking sector portrays an encouraging picture
S0, whereas it rises by 971 bps under S1, by the with capital adequacy staying well above the
end of horizon (Figure 4.9). domestic regulatory benchmark. Under the
hypothetical stress scenario as well, the banking
Small Banks - Gross Non-Performing Figure 4.9 sector is expected to withstand a severe
Loans Ratio
Actual Scenario 0 Scenario 1 slowdown induced by adverse global and
24 percent domestic macroeconomic conditions, including
22
the global commodity market pressures. In
20
terms of size, all the segments of the sector
18
16
(small, medium, and large) can withstand the
14 stressful conditions as well. Reassuringly, the
12 large size banks, whose stability has particular
10 significance for economy and financial system,
8 carry higher capital buffers and are thus able to
6 sustain the impact of hypothesized shocks for
Sep-26
Sep-21

Sep-22

Sep-23

Sep-24

Sep-25
Mar-21

Mar-22

Mar-23

Mar-24

Mar-25

Mar-26

the projection period of three years.

Source: SBP Calculations Also, the other two segments of banks meet the
solvency criteria during the projection horizon.
In terms of solvency, the CAR of small banks Furthermore, if history is any guide, the
falls by 235 bps and 389 bps under S0 and S1 domestic banking sector has generally
from the prevailing level of 25.3 percent (Figure performed quite reasonably during severe
4.10). The CAR, however, remains 1,146 bps downturns, such as the external sector crises in
higher than the local benchmark in S0 while 2008, COVID-19 pandemic and flash floods of
staying 992 bps above the minimum 2022. This is clearly visible in the results of the
requirement under S1. Over time, this segment stressed scenario (S1), as the sector remains well
has strengthened its resilience by substantially capitalized and resilient.
building the capital adequacy levels.

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That said, the exact severity, duration, and paths stress-test results are also subject to significant
of assumed global commodity markets and uncertainty. SBP continues to closely watch the
macro financial conditions due to ongoing evolving situation and remains ready to take
geopolitical tensions in Middle East and Eastern necessary actions to safeguard the financial
Europe remain highly uncertain. As a result, the stability.

Box 4.1: Climate Risk Scenario Analysis

Introduction

Climate change is one of the many structural changes that affect the financial system. The issue has got significant
attention of the financial sector regulators, international organizations and market participants towards
understanding the implications of climate change for the financial sector and its stability. SBP, recognizing its
importance and criticality, has also included climate change as one of the strategic themes in its Vision 2028.12

According to the Global climate risk index, Pakistan is the 8 th most vulnerable country to climate change.13 Over the
years, physical hazards due to climate - related changes have adversely impacted the economy of Pakistan.14 Climate
change may impact the banking sector by affecting the credit worthiness of counterparties or through holding of
financial assets that are vulnerable to climate change. Besides its direct impact on financial sector, climate change can
impact the wider economy, which may in turn affect the banking system.

On a broader level, risks to financial stability from climate change are classified into Physical and Transition risks.
Physical risks include possible economic costs and financial losses resulting from the increased severity and
frequency of climate-change related weather events. Whereas, Transition risks relate to the process of adjustment
towards a low carbon economy including shifts in policies designed to mitigate and adapt to climate change.

Given Pakistan’s economic vulnerability to climate change, an assessment of climate related risks to the banking
sector is crucial. SBP has been incorporating the impacts of climate - related physical risks through demand side
variables in its annual stress testing exercises published in the FSR. Building on the climate risk assessment work
presented previously, this box is dedicated to the scenario analysis of physical and transition risks for the stability of
banking sector of Pakistan.

Physical risk

Physical risks include economic losses from extreme weather events related to climate change as well as long terms
progressive shifts of climate. Physical risk drivers are further classified into acute and chronic. Acute risk drivers
include floods, wildfires, excessive precipitation, lethal heatwaves, storms and cyclones. Chronic risk drivers
encompass gradual degradation caused by climate change e.g. rising sea levels, increase in average temperatures,
ocean acidification and desertification as a result of extended periods of high temperature.

According to United Nations Office for Disaster Risk Reduction (UNISDR) (2014), 75 percent of the natural losses
arising due to natural hazards in Pakistan are attributable to the flooding.15 The floods of 2010 and 2022 have
accentuated country’s vulnerability to these events. On the back of this context, physical risk scenario analysis

* This special section has been prepared with a technical assistance from the World Bank under the “Program to Enhance the
Financial Sector Stability and Crisis Preparedness”. This is a research based analytical note containing staff estimates which are
subject to certain assumptions and limitations and do not represent the official views of SBP.
12 SBP Vision 2028 available at [Link]
13 See the Global Climate risk index published by German Watch
14 German Watch (2017), estimates Pakistan annual average losses from climate change at USD 3.8 billion.
15 See UNISDR (2014), Prevention Web: Basic country statistics and indicators

68
 Resilience of the Banking
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Resilience of The Banking Sector

Lending Portfolio of Banks & MFBs in Flood Vulnerable Sectors/Districts at December 2023 Table 4.1.1
million Rupees
[Link] Sector Banks MFBs
1 Agriculture, forestry and fishing 270,585 193,591
2 Mining and quarrying 532 0
3 Manufacture of food products 215,704 906
4 Manufacture of textiles 229,083 2,056
5 Manufacture of wearing apparel 3,725 206
6 Manufacture of leather and related products 5,868 36
7 Manufacture of wood and of products of wood 239 33
8 Manufacture of paper and paper products 747 2
9 Construction 18,718 1,841
10 Land transport and transport via pipelines 3,245 297
11 Accommodation 491 106
12 Real estate activities 1,709 1
13 Consumer Financing 139,578 37,566
Total vulnerable portfolio 890,226 236,641
Gross Loans as of end December 2023 13,100,595 407,790
Flood vulnerable portfolio (percent) 6.8 58.0
Source: State Bank of Pakistan
presented in this exercise attempts to estimate the incremental credit losses to the banking sector in case of recurrence
of flooding equal in intensity to the floods of 2022. The scope of this exercise extends to the lending portfolio of banks
and MFBs.

For the purpose of this exercise, geographical (district-wise) loan data of banks and MFBs, as of December 31, 2023 is
utilized. For identification of vulnerable sectors16, climate stress tests carried out by various jurisdiction were
reviewed.17 Only the sectoral lending portfolio in the districts affected by floods in 2022 is stressed for this exercise
(Table 4.1.1).

The district wise sectoral lending exposures reveals a stark contrast: only 6.8 percent of banks’ gross loan portfolio,
amounting to Rs 890.2 billion, is disbursed in the affected districts and vulnerable sectors. For MFBs, 58 percent of
their gross loan portfolio, amounting to Rs 236.6 billion, is concentrated in these districts and sectors. On sectoral
basis, agriculture, forestry and fishing are the most vulnerable sector with major share of disbursements followed by
manufacturing of textiles and consumer lending.

Two hypothetical scenarios have been developed to test the resilience of banks and MFBs to another episode of
devastating floods, identical in the intensity to the 2022 episode. The first scenario maps the actual, post-floods
sectoral growth of NPLs over four quarters i.e. Q3CY22 to Q2CY23. This intuitively incorporates the impact of
regulatory relief offered by the central bank and government. A second scenario assesses the credit losses of the
banks in the absence of any such relief. Deterioration in the credit portfolio of institutions during the one - year
window assists in capturing the deterioration in the repayment capacity of the borrowers due to flood related
economic losses.

Scenario 1 - Presence of regulatory reliefs: In this scenario, vulnerable portfolio in flood affected districts is stressed
equivalent to the actual growth in credit delinquencies observed during the one-year period following the floods of
2022. The stress in this scenario is relatively subdued, as banks, in line with SBP guidance, rescheduled or
restructured a significant amount of loans to dampen the impact of floods. Due to the higher concentration of their
portfolio in the flood affected districts and relatively low net worth of their borrowers, MFBs are more vulnerable to

16 These sector are based on ISIC-4 classification of advances.

17 For reference, see climate stress tests conducted by the ECB and Bank of Canada.

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floods as their non-performing loans ratio (NPLR) surges to Pre and Post Shock Infection Ratios Figure 4.1.1
8.3 percent post-shock. Despite, the larger volume of loans (Presence of Regulatory Relief)
extended by the commercial banks in the flood affected
districts, their losses are relatively contained as their Pre-shock Pos-shock
borrowers mainly consist of high net worth individuals and 8.3%
corporates (Figure 4.1.1). 7.6% 7.6%
6.7%
Scenario 2 - Absence of regulatory relief: This scenario is
built on the assumptions similar to the previous scenario;
however, the impact of restructured /rescheduled loans and
any write-offs made by the institutions during the Q3CY22 -
Q2CY23 have been added back.18 Under this scenario, the asset
quality of MFBs deteriorates significantly as their non-
performing loan ratio (NPLR) doubles to 13.4 percent. For
scheduled banks, the infection ratio surges by only 50 basis
points to 8.1 percent, which, nonetheless, translates into a MFBs Banks
substantial amount given large volume of banks’ lending Source: SBP Staff Estimates
portfolio (Figure 4.1.2).

Overall, the MFB sector with relatively higher concentration of

advances in the flood affected areas, is more vulnerable to Pre and Post Shock Infection Ratios Chart 4.1.2
climate-related physical risks compared to the scheduled (Absence of Regulatory Relief)
banks. However, due to the relatively smaller size of their
Pre-shock Post-shock
portfolio, chances of systemic risk for financial sector are
muted. 13.4%

Transition risk
7.6% 8.1%
Transition risks include potential disruptions and economic 6.7%
shocks arising out of transition towards a low carbon
economy. Transition risk drivers include climate policies,
technology and consumer/investor sentiments. Changes in
these drivers may disrupt different sectors of the economy,
especially the financial sector if these changes are abrupt and
MFBs Banks
not planned in advance.

Imposition of carbon tax is a major climate risk mitigation Source: SBP Staff Estimates
policy that may affect the credit risk of banks through their
counterparty exposures. Numerous central banks, regulatory authorities and the IMF have employed the use of
carbon taxation scenarios to study the impact of climate related transition risks on the financial sector.19

For transition risk scenario, the impact of a carbon tax on the Pakistan Stock Exchange (PSX) listed firms’
probabilities of default (PDs) and Interest Coverage ratios (ICR) is explored. Beginning with a carbon tax floor of
USD 5 per ton of CO2 emission (tCO2e), changes in PDs and ICRs of corporates up to USD50/tCO2e20 are presented.

Probabilities of Default
Corporate sector is a major user of bank credit in Pakistan.21 Impact of imposition of carbon tax on the financial

18 Write-off amounts of only Q1 and Q2 of CY23 have been included, whereas restructured/rescheduled amount of all four quarters
is included in the shock.
19 See ECB and Bank of Canada climate stress tests, IMF FSAP for Norway & Chile and transition risk stress tests for Columbia and

Japan.
20 (i) PKR-USD parity rate is the average rate for the month of December, 2023.
21 As of December, 2023, 74.5 percent of the total private sector advances were extended to the corporate sector.

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health of PSX listed firms is estimated in this scenario. To capture the transition risk to the banking sector, evolution
of probabilities of default (PDs) of the firms post carbon tax is assessed.

The workhorse model to estimate PDs is based on Altman Z-score, augmented with the macroeconomic factors.
However, the coefficients have been re-estimated for Pakistani firms by employing a Logit model.

𝐏𝐫⁡(𝒚𝒊 = ⁡𝟏) = 𝚲(𝑿𝒊 𝜷)

𝑾𝑪 𝑺𝒂𝒍𝒆𝒔 𝑹𝒆𝒕𝑬𝒂𝒓𝒏 𝑬𝒒𝒕𝒚 𝑬𝑩𝑰𝑻

𝑿=[ ;⁡ ; ; ; ; 𝑮𝑫𝑷_𝑮𝒓𝒐𝒘𝒕𝒉; 𝑰𝒏𝒕. 𝑹𝒂𝒕𝒆⁡]
𝑻𝑨 𝑻𝑨 𝑻𝑨 𝑻𝑨 𝑻𝑨

Using data on 275 non - financial firms spanning over 2013 to 2022, the model estimates pre-shock PDs. We proxy the
default (𝑦𝑖 = 1) by using firm specific data from SBP’s Credit Registry, where a firm is taken to have defaulted if its
credit obligations remain overdue by 90 days and above (OD ≥ 90).

For post-shock analysis, relevant variables are adjusted for the amount of carbon tax. The tax is calculated based on
the level of sales of firms and their carbon intensity. Specifically,
Evolution of Sectoral PDs in Response to Carbon Tax Table 4.1.2
Tax Rate (US$)
Sector Carbon Intensity No tax 5 10 20 25 30 50
(per million US$ Sales) Probabilities of Default (percent)
Fuel & Energy 2,036 14.6 14.8 15.0 15.5 15.8 16.1 17.6
Cement 888 1.9 1.9 2.0 2.0 2.1 2.1 2.2
Chemical 888 2.5 2.6 2.7 2.9 2.9 3.0 3.4
Textile 501 19.7 19.7 19.8 19.9 20.0 20.1 20.3
All 13.8 13.8 13.9 14.0 14.1 14.2 14.5
ECL* (billion Rupees) 136 139 142 149 153 157 175
GNPLR (percent) 7.6 7.6 7.6 7.7 7.7 7.8 7.9
*Expected Credit Loss = LGD x PD x EAD
Source: S&P Global (Intensities) and SBP Staff Calculations

Emission⁡ = ⁡ [Sales⁡ ÷ ⁡Threshold] × Intensity,

Where, ‘Threshold’ is the PKR equivalent of one million US dollars (≈ PKR 282 million), assuming exchange rate of
PKR 282 against USD. The Carbon ‘Intensities’ for the sectors are proxied using Standard & Poor’s data on
greenhouse gas emission of global industries.22 Intensities for sectors under study are given in Table 4.1.2.

Finally, the Carbon Tax is given by

Carbon⁡Tax = Emission × Tax⁡Rate

The tax rates ranges from USD 5/tCO2e to USD 50/tCO2e (in equivalent PKR). Incidentally, IMF (2021) suggests a
floor of USD 25/tCO2e for lower income emerging countries.23 Also, as per World Bank’s Carbon Pricing Dashboard,
30 jurisdictions have imposed carbon taxes in the range of 1 USD/tCO2e (Ukraine) to 156 USD/tCO2e (Uruguay),
with an average tax of USD36/tCO2e.24 Therefore, the tax range used in the study is well within the plausible range.

22 See S&P (2021), “Transition Risk: Historical Greenhouse Gas Emissions Trends for Global Industries” for sectoral emission
intensities.
23 Parry, I., Black, S., & Roaf, J. (2021). Proposal for an international carbon price floor among large emitters. Staff Climate Note No.

01 of 2021, International Monetary Fund.

24 World Bank (2023). State and Trends of Carbon Pricing Dashboard.

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The Logit estimates put pre-shock average PD25 of the corporates at 13.8 percent, which surges by 78 basis points
(bps) to 14.5 percent in case of imposition of a 50 USD/tCO2e carbon tax (Table 4.1.2).

A marginal increase in the PD at this higher level of tax implies the financial resilience of Pakistani corporate sector.
Among major sectors, Fuel & Energy and Chemicals sectors exhibit the highest vulnerability to carbon tax, given
their higher emission intensities, as their PDs rise by 300 bps and 90 bps, respectively from pre-shock levels of 14.6
percent and 2.5 percent. Textile sector, with the largest share of corporate lending and relatively higher pre-shock PD
(due to a few firms in tail of PD distribution) remains resilient in response to the imposition of carbon tax which
signifies two facts: first, robust financial health of firms (as the mass of PDs is concentrated below 30 percent), and,
second, low assumed carbon intensity.

The sectoral PD distributions suggest minimal migration of firms from safe (< 𝟎. 𝟓) to the default zone of (> 𝟎. 𝟓).
Post tax, distribution for Fuel & Energy, Chemical and Cement sectors reflect some rightwards movement i.e. rise in
PDs, however, no migration to the default zone is observed for any of the firm in these sector (Figure 4.1.3).

Sectoral PD distribution Figure 4.1.3

Source: SBP Staff Calculations

Density distributions correspond to a US$ 50 tax

Results of the exercise provide some evidence that carbon tax could impact the PDs of firms in the sectors with higher
emission intensities; however, the magnitude of increase in PDs is relatively contained and likely to have
commensurate impact on the solvency of the banking system. This can be gauged from the fact that the credit risk

25 These are staff model based estimates and shall not interpreted as official SBP view.

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Resilience of The Banking Sector

due to carbon tax (US$ 50) results in an incremental expected credit loss26 of only Rs 39 billion. As a result, the infection
ratio may increase from current level of 7.6 percent to 7.9 percent at maximum tax levels.

The PD model, however, relies on a multitude of factors, some of which are strong enough to dampen the aggregated
impact of a carbon tax on the PDs of corporates. Resultantly, no sizeable migration of firms to the default zone is
observed.

Interest Coverage Ratio:

To isolate the impact of transition risk on the debt repayment capacity of non-financial corporates, a potential source
of increase in credit risk of the banking sector, changes in interest coverage ratio (ICR) of the non-financial firms in
response to the imposition of a carbon tax are analyzed.

The ICR is defined as the extent of (or times/multiples) a firm’s earnings before interest and taxes (EBIT) to cover the
interest payments. Balance sheet and firm level emission data is utilized to estimate changes in the PSX listed firms’
coverage ratios for carbon tax levels up to USD 50/tCO2e.
Median ICR under Carbon Tax Figure 4.1.4
Estimates of this analysis assume that firms fully absorb the Scenario for Listed PSX Firms
carbon tax levied on their emissions. However, in practice
output prices, quantities, production processes and inputs
5.5
would all adjust to a transition. Modelling these dynamics is 5.3
5.1
highly complex and beyond the scope of this exercise. 4.7
4.6
Therefore, these results may be interpreted as an upper bound 4.4
of the financial impact on firms due to the carbon taxation.
3.5
The median ICR of the listed firms, pre-tax, stands at
comfortable 5.5X (Figure 4.1.4). With a carbon tax of USD
25/tCO2e, a floor suggested in the IMF (2021), the median ICR
drops to 4.6X while with a tax of USD50/tCO2e, it further
drops to 3.5X. No tax 5 10 20 25 30 50
Carbon tax in US$
Median ICR numbers with carbon taxation are comfortable;
however, there are some firms with weaker financial position. Source: SBP Staff Estimates
Pre-shock, the share of firms for which EBIT does not cover
interest payments (ICR < 1X), i.e. debt-at-risk, is 5 percent and Share of Firms with Debt at Risk Figure 4.1.5
another 11 percent of the firms have an ICR between 1X and
2X. ICR<1 1<ICR<2

The number of firms with debt-at-risk substantially increases

with the imposition of carbon tax. For instance, at USD
25/tCO2e, the share of firms with an ICR below 1X doubles to 14%

10 percent whereas with a per ton carbon tax of USD 50, the
share increases to 20 percent (Figure 4.1.5). Because of the 13%
14%
14%
significant increase of the debt-at-risk in the case of a USD50 12% 12%
11% 20%
tax, banks’ credit risk would surge. Specifically, with
implementation of IFRS-9, the transition adjusted expected 7% 8% 10% 11%
5% 6%
credit losses of banks may rise.
No tax 5 10 20 25 30 50
At sectoral level, Fuel & Energy followed by the Chemical and Carbon tax in US$
Cement are the sectors most vulnerable to carbon taxation.
This is expected given high emission levels in these sectors, Source: SBP Staff Estimates

Expected Credit Loss (ECL) = LGD x PD x EAD. NPL provision coverage ratio is used as a proxy for Loss Given Default (LGD),
26

PDs are model based estimates and Exposure at Default (EAD) is the quantum of outstanding performing loans of the firms.

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Share of Firms at Sectoral Level with Debt at Risk Figure 4.1.6

In percent, ICR < 1, Carbon tax in US$

65%

Fuel and Energy

Cement
31%
27%
23%
19%
12% 13%
7% 7% 7% 7% 7% 7%
0%

No tax 5 10 20 25 30 50 No tax 5 10 20 25 30 50

Chemical
Textile
30%

15% 17%

4% 4% 4% 6% 7%
1% 1% 1% 3% 3% 3%

No tax 5 10 20 25 30 50 No tax 5 10 20 25 30 50

Source: SBP Staff Estimates

and it also suggests greater vulnerability of these sectors to transition risk. At a tax rate of USD25/tCO2e, suggested
in IMF (2021) for keeping the emissions below 2 o C, 27 percent of the firms operating in Fuel & Energy sector may
face impairment of their debt repayment capacity i.e. ICR<1. Share of Banking Sector's Exposure Figure 4.1.7
Percentage of firms in other sectors with debt-at-risk are to PSX Listed Firms at Risk
estimated at 15 percent for Chemical and 3 percent for Textile
(Figure 4.1.6). ICR < 1 1 < ICR < 2
9%
Banks’ exposure to transition risk is indirectly linked to their
10%
lending to corporates that may face a decline in their
repayment capacity in response to the imposition of a carbon
tax. Pre-shock, 9 percent of the banking sector’s exposure to 7% 7% 7%
41%
PSX listed firm is at-risk (ICR<1X). At a carbon tax of 15% 13%
33%
USD25/tCO2e, 21 percent of the banking sector’s lending 19% 20% 21%
portfolio becomes at–risk, which further increases to 41 9% 12%
percent at a tax of 50 USD/tCO2e (Figure 4.1.7). Therefore,
depending on the strategy to achieve the net-zero target, a No tax 5 10 20 25 30 50
gradual path with low carbon tax would entail a low transition Carbon tax in US$
risk while a more aggressive one with higher tax levels may
enhance credit risk of the banking sector. Source: SBP Staff Estimates

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