WASHINGTON - Moodys Investors Service has kept its negative outlook on Pakistans banking system due to its increasing exposure to government debt and deteriorating asset quality, reports Dow Jones. We expect that banks will further increase their already very high exposures to the B3-rated sovereign, as the subdued economy constrains corporate and household loan demand and limits the banks risk appetite, said Christos Theofilou, a Moodys analyst, in the report released Monday. Heavy flooding in August 2010, the worst in the nations history, caused a humanitarian disaster and precipitated deteriorating macroeconomic conditions, which have weakened the banks operating environment, the rating agency said. The firm expects weaker economic growth and higher inflation in the short term as the floods have led to food shortages, rising commodity prices and a renewed recourse of the government to deficit monetization. Moodys estimates that government-related exposures amounted to a very high 36% of rated Pakistani banks total assets as of end-September 2010, making these banks increasingly susceptible to event risk at the B3-rated sovereign level. Our stress scenario analysis highlights the risks emanating from banks sizeable exposure to the broader government sector. In the near term, higher inflation may lead to rising lending rates, which, together with the weakened economy, will challenge borrowers payment capacity, contributing to further asset-quality deterioration for banks, it said. While the rated banks capital levels are sufficient to absorb either a severe deterioration in their asset quality or a moderate government default scenario, their capital cannot withstand a combination of these two stresses, it said. It expects that banks will continue to focus on attracting low-cost current account and savings account deposits, estimated to account for 70% of the rated banks total deposits and 56% of total assets at the end of September 2010.