The financial institutions are required to classify their loans/advances portfolio and make provisions in accordance with the criteria prescribed in new PRs


Dec 15 - 21, 2003



The State Bank of Pakistan (SBP) has issued three sets of Prudential Regulations (PRs) under BPD Circular No. 35 dated October 28, 2003 for compliance by all banks and DFIs. The PRs are for Corporate Banking, SMEs Financing and Consumer Financing. New PRs shall become effective from January 1, 2004. These PRs do not supercede directives and instructions issued by SBP in respect of areas not covered under above regulations, which also include the instructions on penalties. The Banks/DFIs (financial institutions) have been advised to ensure circulation of PRs for meticulous compliance in letter and in spirit. Non-compliance will lead to punitive action under relevant law. Moreover, transactions structured to circumvent PRs will tantamount to violations and shall be dealt with accordingly.

Financial crises can be highly damaging for financial institutions and economies. The financial regulators all over the world have been taking measures for improving financial sector regulation and supervision. New PRs aim at protecting deposits and the banking system.

The senior management and the respective board of directors (BODs) have to carefully review new PRs. The financial institutions may adjudge new PRs for practicality, cost of compliance, and impact on business growth. Regulations considered 'excessive' might be brought to SBP attention. Problem may arise in areas such as exposure limits for persons or groups; group definition and group companies; loan loss provision guidelines; limit on clean facilities; loan securities and perfection of documentation/charge; duties of BODs vis-a-vis meeting of fee payments; role of Compliance Officer vis-a-vis Internal Auditor; ascertaining use of funds by borrowers; and determination of Forced Sales Value. Problem areas might first be considered at Pakistan Banks Association, before approaching SBP for clarifications. The borrowers would also review new PRs and might raise issues with SBP on 'excessive' regulations.

The financial institutions shall be making preparations for effectively implementing the new PRs by January 1, 2004. In the process, organization structure and design of their operations may perhaps be adjusted to provide good services to the customers. The switch over to new PRs should not be a big problem provided it is orderly and gaps identified in personnel, policies, etc are immediately plugged. Aim is that activities pertaining to deposit taking and extending financial facilities are handled diligently in full compliance of applicable laws and prescribed PRs. The DFIs and foreign banks, with fewer branches and selected clientele, might handle transition more easily. Local banks may have to mount major efforts. Following suggestions might facilitate the transition.

The financial institutions are required to ensure circulation of new PRs among all their offices/branches for meticulous compliance in letter and in spirit. Presently, new PRs for SMEs and Consumer Financing only have Risk Management "R" section. These would be completed only after adding three sections from PRs for Corporate Banking, namely "G" for Corporate Governance, "M" for Know Your Customer & Anti Money Laundering and "O" for Operations. It would be up to the financial institution to print one volume containing the set of three PRs or three different self-contained volumes for Corporate, SMEs or Consumer financing. A dedicated Cell might be useful in each institution to immediately circulate up-dated portion of PRs, when SBP issues an amendment or change.



New PRs prescribe that BODs should know policies, focus on policy making/approval and leave day-to-day operations to senior management. Some existing policies might need updating; while others might have to be written afresh. The BODs should take stock of existing policies and make arrangements for preparation and implementation of all prescribed polices. Other important matters that BODs may attend include constitution of committees/audit committee, formats of reports regarding different financial facilities, MIS on operational performance; databank on trade, industry, government policies and regulations; compliance with laws, rules and regulations; proper writing of minutes; and timely receipt of Management Letter from external auditors. The financial institutions may adopt 'Truth-in-Lending' and clearly disclose to the customers by printed brochures, all important terms, conditions, fees, charges and penalties.

The SBP has prescribed Fit and Proper Test for appointment of President/Chief Executive, BODs and key executives. The BODs and senior management should ensure that all existing key officers meet the fit and proper criteria. New PRs require arms length dealings with directors, employees, investors and customers. Appropriate proformas might be developed for seeking details on matters referred to in the PRs from directors as well as the employees. Professional training of officers particularly those handling the financing facilities might be undertaken, supplemented by on-the-job training under experienced hands. Similarly, application forms and other formats prescribed by SBP might be properly filled in and duly signed and stamped by the customers.

It may be noted that exposure limits have exemptions due to security or sector and are linked to the equity of the institution. As such, determination of total exposure to a company and the group might involve detailed calculations. It is imperative that all linkages and exemptions are understood properly. To cope with the work load with large number of customers and depositors, suitable computer applications shall have to be devised and installed. The financial institutions must develop guidelines/proformas for internal use so that appraisal, credit reports, reports on eligibility of borrower/group, existing exposure, exposure if loan request is accepted, documentation, releases, use of funds etc are properly streamlined and authorized.

The financial institutions are allowed, subject to a number of exemptions, exposure due to contingent liabilities up to ten times of their equity. Disregarding the exemption, the exposure could be higher than ten times. It would be prudent to also periodically calculate gross exposure on total contingent liabilities. Credit rating of the banks providing guarantees on behalf of the customers need to be watched.

For corporate clients the exposure per person has been fixed at 30% of financial institution's equity (of which maximum 20% fund-based) whereas for the Group it is 50% of equity (of which maximum 35% fund-based). Per person financing exposure for SMEs and Consumers has been fixed in monetary terms while overall exposure has been linked to the equity of financial institution. Therefore, the financial institutions shall have to carefully monitor movements in its own equity. Any abrupt fall in equity say due to a large provision for one or more doubtful debts might reduce equity; and as a consequence exposure against some of the borrowers might exceed prescribed limit and attract penalty from SBP.

Revaluation reserves play a part in the determining exposure limit of a borrower for the first three years of valuation. In this regard it has been provide that assets must be prudently valued by valuers on the panel of Pakistan Bank Association. Valuation of assets is a critical area and the financial institutions, through PBA, might consider adopting fair and transparent procedures in selection and monitoring of the valuers.

New PRs have defined 'the Group' and specified an exposure limit, which is larger than the limit for an individual borrower. The financial institutions would surely face confusion and problems in determining the list of companies that form a group according to the definition. The banks and the borrowers might not have sufficient details and therefore not agree in all cases on the subsidiary or parent company relationship, control, substantial interest, significant influence, financial interdependence and eligibility of a company if another company of same group is in default. A system has to be in place to keep track of different groups and their exposures with all institutions.

The financial institutions have to ensure that loans have been properly utilized by the SMEs and for approved purposes. An appropriate system should be developed and implemented for monitoring the utilization of loans. It may be noted that the assets developed through loans/equity generally provide main security to the financial institutions. It must be noted that misuse or pilferage of the loan funds/equity funds would dilute loan security and adversely affect debt servicing performance. As such, financial institutions must pay more attention to procurement monitoring of SMEs and other customers.

The financial institutions are required to classify their loans/advances portfolio and make provisions in accordance with the criteria prescribed in new PRs. They have been allowed transition period up to December 31, 2004 to regularize their provisioning position. It will be useful if causes of loans turning sour are also determined and lessons used for future loaning or restructuring operations.