OUR STAFF REPORTER LAHORE - The banking sectors continued focus on building their investment portfolio kept advances growth muted for some time in the aftermath of the second policy rate cut by the State Bank of Pakistan (SBP) during FY12 by a magnitude of 150bps to 12 percent. According to banking sector experts, despite the rate cut, strategy of most of banks would continue to be geared towards investment in government securities for time being due to preference for minimum credit risk and guaranteed returns. An analysis reveals that DR cut on banking valuations would impact the banking companies in three different ways: adverse impact on NIMs, lower yields inflating capital gains on investments, and spurring credit growth and improving asset quality in the longer run. At the same time, cautious deposit growth and reshuffling of deposit to inexpensive deposits had boded well for the banking sector during CY10 and 1HCY11. The same is reflected in Investment to Deposit Ratio (IDR) increasing rapidly to 50 percent in AugUST 2011 compared to 39 percent last year with Advances to Deposit Ratio (ADR) declining to 57 percent from 65 percent last year. Additionally, banks invested Rs553 billion in 12M T Bill during 1QFY12 (65 percent of total) in a bid to lock in higher interest rates. Experts said that large-cap banks tend to have stronger earnings power at the pre-provision level. They believe that this is partly driven by strong deposit franchises and strong distribution franchises. The same has been reflected in National Banks (NBP) earnings which is expected to suffer the least (down by 9 percent in CY12E) compared to Bank Al Falah (BAFL) which will likely see a 16 percent drop in its bottom line in CY12E. Reducing the risk-free rate assumption to 12.25 percent from 13.50 percent earlier raises the JPBV multiple; combined with earnings compression over CY12-14E leads to a net positive impact on our TPs with the largest impact on NBP and least on BAFL. It has been observed that banks with strong deposit franchises are likely to maintain costs of deposits at levels lower than peers. Furthermore, costs of deposits have generally been found to be downward sticky while loan re-pricing is conducted after every three months. Therefore, large-cap banks tend to generate stronger NIMs, despite lower ADRs. For instance, MCB Bank (MCB) has the highest NIMs of 8.6 percent as of Jun11 with the lowest ADR at 57 percent. However, the bank also holds the largest exposure of 45 percent to savings deposits on which a minimum of 5 percent has to be paid to the depositors. Experts believe this will lead to a drastic decline in its NIMs in CY12E (down by 160bps). Looking at it from another perspective, MCB derives the largest proportion of 39 percent of its PAT from its total income (NII + Other Income) and therefore, the impact on the bottom line expected to be the second lowest (down by 12 percent in CY12E and 6-7 percent in CY13-14E) after NBP (9 percent in CY12E). In comparison, BAFL whose earnings form only a small proportion (5 percent) of its total income immediately sees a large impact on its bottom line with loan re-pricings, given relatively higher deposit costs than peers. Further, 29 percent of BAFLs deposit base is composed of fixed deposits which will keep its costs on the higher side going forward. Post the DR cut, 6M KIBOR has dropped to 11.94 percent, level last seen in Jul09; lower yields raise asset prices and result in capital gains. MCB with the highest exposure (94 percent) to government securities with a majority in T Bills (88 percent of total investments) stands to gain the most. However, conversation with management revealed that the bank will not realise these gains in 4QCY11 and will instead maintain its strategy of placing its money in risk-free instruments till further cuts emerge. BAFL and United Bank (UBL) will be other big beneficiaries of the same which holds 73 percent and 69 percent in government securities respectively. Loan re-rating on the back of declining KIBOR is expected to yield some relief for borrowers. Further, in case reversals in NPLs materialise going forward, it is going to be an added positive for the banking sector; we believe NBP stands as a key beneficiary of the same as its NPLs rose by a massive 25 percent in 1HCY11. Thirdly, conversion of power sector loans and TFCs into PIBs will make further room for credit growth. However, appetite for further credit growth remains muted based on continued govt borrowing.