High yields cause Rs600b losses

Banks' capital buffers erode; fixed-income rout wipes out sector gains

KARACHI:

Pakistan's commercial banking sector is bracing for a major financial shock, as a sharp spike in interest rate yields is expected to wipe out more than Rs600 billion in revaluation surpluses within a single quarter.

A report by Optimus Capital Management, titled 'Back to Square One', warns that the rapid shift in the fixed-income market has "largely exhausted" the cushion banks had built in recent quarters to absorb volatility. The erosion in these reserves marks a reversal of earlier gains, effectively resetting the sector's balance sheet strength.

According to the analysis, secondary market yields surged by approximately 150 basis points (bps) between December 2025 and March 2026. This increase has led to a steep decline in the market value of government securities held by banks, resulting in widespread mark-to-market losses.

The report estimates gross revaluation losses for the banking sector at around Rs685 billion. After adjusting for existing surpluses, the net impact stands at a deficit of roughly Rs95 billion across major institutions, highlighting the scale of the stress on bank balance sheets.

Leading banks bear the brunt

Among the largest players, United Bank Limited (UBL) is seen as the most exposed due to its higher sensitivity to interest rate duration. Analysts estimate a post-tax impact of approximately Rs117 billion on UBL's book value. Habib Bank Limited (HBL) and National Bank of Pakistan (NBP) are also expected to face substantial losses, with estimated impacts of Rs54 billion and Rs45 billion, respectively.

The report cautions that risks in the banking sector have "increased materially" in the rising yield environment. Any further upward movement in interest rates could begin to erode Common Equity Tier-1 (CET-1) capital ratios, potentially forcing banks to adopt more conservative dividend policies and capital management strategies.

Understanding the valuation losses

primary driver of the current stress is the mark-to-market adjustment on banks' large holdings of government debt. As yields rise, the prices of previously issued lower-yield bonds decline in the secondary market, leading to accounting losses on investment portfolios.

Given that Pakistan's banks are heavily invested in sovereign instruments, even a relatively modest increase in yields can translate into significant valuation losses. The recent 150bps shift has therefore had an outsized impact, wiping out a large portion of the revaluation reserves accumulated during the previous low-yield environment.

This inverse relationship between yields and bond prices is a fundamental dynamic of fixed-income markets. Bonds issued at lower fixed rates become less attractive when new securities offer higher returns, forcing their prices downward to align with prevailing market yields.

The report attributes the surge in yields partly to the government's increasing reliance on short-term liquidity support. The State Bank of Pakistan (SBP) has expanded its use of Open Market Operations (OMOs), which now finance about 24% of domestic debt. This reliance has contributed to volatility in the fixed-income market, particularly as liquidity conditions tighten and borrowing requirements remain elevated.

In addition, the composition of public debt has shifted significantly, with floating-rate instruments now accounting for more than 50% of total outstanding debt. While these instruments provide flexibility for the government, they introduce new risks for banks.

The report highlights the emergence of "meaningful spread duration risk," noting that floating-rate securities can transmit interest rate volatility more quickly into bank earnings and capital positions compared with traditional fixed-rate bonds.

Profitability outlook remains stable

Despite the significant hit to book value, the report draws a clear distinction between accounting losses and underlying profitability. Analysts do not expect a major immediate impact on bank earnings, aside from the usual lag in repricing assets and liabilities.

Over time, banks are likely to benefit from higher interest rates as they reprice loans and reinvest in higher-yielding securities. This could support net interest margins and earnings growth, although the benefits may take time to fully materialise.

The impact of the yield shock is not uniform across the sector. Banks such as Bank AL Habib (BAHL), Meezan Bank (MEBL) and MCB Bank (MCB) are considered relatively better positioned to weather the current environment. These institutions maintain shorter-duration portfolios or have lower exposure to fixed-income securities, limiting their vulnerability to mark-to-market losses. As a result, they are expected to recover more quickly as market conditions stabilise.

Looking ahead, the trajectory of the banking sector will depend significantly on the response of regulators. Historically, the SBP has provided relief measures during periods of heightened volatility to prevent banks from breaching minimum capital requirements. However, the report notes that the current environment presents unique challenges due to structural changes in debt composition and the increased role of floating-rate instruments.