The SBP has required all NBFIs for meticulous compliance, as non-compliance will lead to punitive action


July 29 - Aug 04, 2002


The State Bank of Pakistan (SBP) for the last few years has been consolidating the Rules of Business for the NBFIs (RBs) and the Prudential Regulations for Banks (PRs) in the form of booklets. Periodically or as need arises, existing RBs or PRs are amended, substituted or new directives issued for compliance respectively by the NBFIs and the Banks. Due to close monitoring of the situation by the SBP, the number and variety of the RBs and PRs has grown over the years. This clearly shows the dedicated efforts of the SBP in this regard. An updated edition of RBs consolidating amendments up to March 31, 2002 has been issued under BPD Circular Letter No. 13, dated May 22, 2002. Also, the updated version of the RBs has also been placed at the SBP website. The SBP has required all NBFIs for meticulous compliance, as non-compliance will lead to punitive action.

The RBs include directives pertaining to different aspects of NBFI operations such as limits on exposures, building up of reserves, focusing on principal business, return on deposits and insurance thereof, maintenance of liquidity, link of total borrowings to borrowers' equity, limit on exposure to single borrower, financing facilities against shares, facilities to small entrepreneurs, provisioning for non-performing assets, submission of audited accounts, role of internal audit, prevention of money-laundering, credit ratings, margin against facilities and submission of statistical returns to the SBP.

Compliance with the RBs is expected to strengthening the financial sector in addition to profitable operations of NBFIs, earning good returns to the shareholders and income tax to the government. In case the NBFIs experience problems, the society and the financial sector suffer in addition to the shareholders and the creditors. As such, the RBs are also of interest and concern to the public. There is, therefore, a need to bring to the attention of the SBP such business aspects that have been inadequately covered in the RBs or certain matters that are not progressing as desired. With this objective, the latest version of the RBs has been reviewed and the following suggestions are submitted to the SBP for consideration:

In the Preface to the RBs updated up to 31st March 2002, it has been said that the RBs do not supersede margin restrictions and other directives issued by the SBP from time to time in respect of areas not covered by the RBs. In this context it is suggested that such directives may preferably be also included in the RBs proper and those few that cannot be so reflected, a reference to them may be made in the relevant RBs. This will enhance the usefulness of the RBs and it will be also more beneficial to the NBFIs' personnel for compliance purposes.

RBs define the NBFIs to include DFIs, investment banks, Modarabas, leasing companies, discount houses, housing finance companies and venture capital companies. This is a very broad spectrum of our financial sector. The same set of instructions, howsoever expertly designed by the SBP, might not be fully responsive to the operations of some of the institutions. It is suggested that separate set of instructions might be considered particularly for housing finance companies and the venture capital companies. Housing construction is lagging behind and promotion and financing of this sector is a priority area of the government at present. Similarly, the promotion and funding of SMEs is critically important for increasing exports, employment generation and kick starting the economy. In Pakistan, so far the venture capital activity for promotion of SMEs has been negligible. The SBP guidance may make the housing finance companies and the venture capital companies take needed initiatives for improving conditions in Pakistan.

Mobilizing funds and utilizing those funds by way of loans, purchase of shares / TFCs or underwriting thereof, sometimes coupled with financial advisory, are the principal activities for majority of the NBFIs. These activities contribute major income to the financial institutions concerned. In my view, the approval or commitment stage of the above activities might be covered more extensively in the RBs. Much more attention might be given to activities such as scrutiny of applications, approval of financial assistance and the compliance of the terms and conditions governing the financial commitments. Exhaustive reporting requirements and / or precautions at later stages may help but not compensate the poor decisions taken at initial stages. In view of experience of large loan defaults in the past, I would urge the SBP to particularly focus attention in improving these areas.

Some three years ago, the NBFIs were asked to submit to the SBP, manuals / guidelines / policies on important areas such as credit, monitoring, control procedures, internal audit, recruitment / promotion, after approval of the respective Boards of Directors. The SBP may make a reference to such documents / policies in the RBs, and require compliance from the concerned NBFIs. This is expected to improve NBFIs' operations.

RBs prescribe exposure limit on NBFIs' liabilities in relation to equity (Rule 1). For initial two years of operation it is 7 times whereas for subsequent years it is 10 times. Similar exposure limits are available in respect of contingent liabilities (Rule 2). In my view, the above exposure limits are over generous and must be brought down for both the categories, especially for the initial few years. This may save some of the institutions from the fate met by a number of DFIs in the recent past.

It has been provided (Rule 4) that every NBFI shall arrange full insurance cover to its deposits / COIs up to Rs 100,000 when deposit insurance arrangements are in place. The depositors have been expecting such insurance cover since long. The SBP is urged to put such arrangements in place, in cooperation with the GOP, preferably before the end of this financial year.

Return on deposits (Rule 5) to the depositors are low (after adjusting for Zakat and the withholding tax) as compared to the rates at which funds are advanced / loaned by the NBFIs and Banks. The intermediation margin enjoyed by these institutions is in the range of 5 to 9% and they show handsome profits. In the interest of the depositors, the SBP is urged to rationalize these rates to ensure that the depositors get a fair net return and that the financial institutions do not exploit the situation.

Rule 7 links total borrowings to the borrowers' equity. The borrower can avail the total fund based facilities up to 10 times of its capital and reserves. Subordinated loans and the Revaluation Reserves reflected in the accounts of the borrower and audited by an approved firm of Auditors are also treated as part of equity for this purpose. In my view, this limit is exceptionally high in the present day volatile situation in Pakistan. It may be realized that losses for one year to a company operating with such high borrowings, may push the exposure to as high as 20 times or more. To correct the situation, the borrower or for that matter the lender institutions will not be able to do much in the short term. In order to avert aggravation of existing high bad loans situation, the SBP is urged to rationalize this linkage and reduce it to a lower and safer level. As regards the role of the Auditors in the creation of the Revaluation Reserves, it is suggested that the SBP, in the wake of the Enron debacle, may consider further strengthening the rules / guidelines / checks and balances for the Auditors.

Maintenance of Current and Debt-Equity Ratios (Rule 8). In addition to these ratios, there is need to prescribe Debt Service Coverage Ratio say not below 1.25 times. This measure is equally important in view of the prevailing bad loan situation.

RBs provide that the total exposure to any single person at any time shall not exceed 30% of the NBFI's unimpaired capital and reserves (Rule 9) subject to the condition that the maximum outstanding against fund based facility do not exceed 20% of the unimpaired capital and reserves. I feel, these are exceptionally high limits and the SBP may consider reduction. Such high limits are generous in situations where the credit risk is minimal. In our situation we have to be more careful and conservative. It may kindly be noted that with one default by the borrower in the non-fund based facility, these high limits will be seriously disturbed. In such situations the borrowers express helplessness for corrective action and the NBFI suffer most.

Rule 14 dealing with the classification and provisioning for assets is very important. The first part of this Rule specifies the time-based criteria for loans classification, treatment of the accrued income and the provision to be made for the possible losses. Part two of this Rule requires that in addition to the time-based criteria, subjective evaluation of performing and non-performing portfolio for risk assessment may be made and where considered necessary the category of classification to be further downgraded. It has been prescribed that such an evaluation shall be carried out on the basis of adequacy of security including its realizable value, cash flow of borrower, documentation covering advances, credit worthiness of borrower, etc. Risk assessment is an important but complex area and for this you need trained and experienced personnel. It is suggested that a detailed new Rule on risk assessment may be inserted in the RBs and the financial institutions may be required to carry out risk assessment particularly at appraisal and disbursement stages through experienced and qualified personnel. It may please be noted that risk assessment is needed more at the time of approval and release of the financial assistance. At later stages it helps to some extent but it will not be much help if the risks were not adequately identified or covered at approval or disbursement stages.

NBFIs have been required to become member of an association, constituted in consolation with the SBP. Such association shall frame a Code of Conduct (Rule 20) for the members and ensure compliance therewith. Although an Association is already there but it appears the Code of Conduct has not been adopted. In this context attention is invited to the Code of Conduct circulated by the ADFIAP (the Association of Development Finance Institutions in Asia and Pacific) about three years ago to its member DFIs in Pakistan. This is a three-part document. Part-I is Statement of Common Values and Beliefs of Members, Part-II is a Framework of Code of Conduct for Member Institutions and Part-III is a Framework of a Code of Conduct for the Officers and Staff of Member Institutions. The Association in Pakistan may possibly consider it for adoption. Alternatively, it may be used as starting point and finalized after modifications agreed in a joint meeting convened by the Association for the purpose. The SBP might consider fixing a time limit for the adoption of an appropriate Code of Conduct.

All NBFIs are required (Rule 21) to have an Internal Audit Department. The head of this department reports directly to the Board of Directors or the Audit Committee constituted by the Board. It has been said that he / she will be interalia, responsible for compliance with these rules. The compliance responsibility, in my view, is that of the Board of Directors and the Chief Executive, who wield the executive power and the RBs should specifically provide that. As regards the Internal Auditor, he / she may be required to verify if the specified important actions are in compliance with the RBs' requirements. Such actions may include verification of loan exposure limits, release of loan funds, release of security, etc.

The SBP has prescribed (under Rule 27) that the Borrowers will also submit to the NBFI, duly signed and sealed, Basic Fact Sheet as per format, and no financing facility will be approved by any NBFI if properly completed BFS is not received. There are two formats of BFS: one for the Corporate Borrowers and the other for the Individuals / Consumers. It is suggested that for Corporate Borrowers, BFS may also be required from all sponsoring directors of the company about them and the other businesses in which they are or were interested in the past.

There are a number of common areas between the Rules of Business for the NBFIs and the Prudential Regulations for the Banks. To the extent of the common areas, the suggestions submitted here may also be considered for the Prudential Regulations for the Banks.