A tool for disciplining corporate lending

Mar 01 - 07, 2004




The State Bank of Pakistan (SBP) through a circular dated 21st January 2004, has conveyed instructions to the banks and DFIs that after 31-01-2004, the Karachi Inter-Bank Offered Rate (KIBOR) of one, three & six-month tenor, and other longer tenors as made available, shall be used as a benchmark rate for determining pricing of all Rupee Corporate/Commercial banking lending in terms of the Prudential Regulations. The decision has been made with a view to encourage transparency, promote consistency in market based pricing and improve management of the market risks undertaken by the banks. The benchmarking was announced after a meeting on that day between the SBP officials and the Chief Executives of all banks, under the Chairmanship of the Deputy Governor. The banks have been advised for strict adherence with the procedure of benchmarking to KIBOR and the following instructions:

1. THE BENCHMARKING WILL BE APPLICABLE TO: (i) All Floating and Fixed Rate Time Loans/TFCs/Commercial Papers with reset dates (where applicable) within the available KIBOR tenors up to 6 months which is to be increased to 12 months by March 31, 2004 and thereafter to 3 years by December 31, 2004; and (ii) Overdraft and Running Finance obtained/renewed after 31 January 2004.

2. FOLLOWING METHODOLOGY WILL BE USED FOR USING KIBOR AS THE BENCHMARK RATE: (i) KIBOR is defined as the Average rate, Ask Side, for the relevant tenor, as published on Reuters page KIBOR or as published by the Financial Markets Association of Pakistan in case the Reuters page is unavailable; (ii) Banks and the borrowers are free to decide on the relevant tenor of KIBOR and the spread over KIBOR at their discretion; (iii) KIBOR will be set for the lending facility on the date of draw-down or on the markup-reset date; and (iv) Offer Letter to the client should clearly indicate the KIBOR's tenor plus agreed spread, frequency of revision etc.

3. FOLLOWING EXEMPTIONS WILL BE AVAILABLE FROM THE REQUIREMENT OF USING KIBOR AS BENCHMARK RATE: (i) Financing under Export Finance Scheme of the SBP, rates of which shall continue to be determined as per instructions issued by the Banking Policy Department of the SBP; (ii) Lending provided by the banks in terms of the Prudential Regulations relating to Consumer financing and SME Financing; (iii) The Overdraft and Running Finance facilities extended up to 31 January 2004. These shall, however, be benchmarked to KIBOR at the time of renewal of the facility or when the same is due for re-pricing; (iv) All TFCs/CPs approved by SECP and/or submitted to any stock exchange, provided the requests for necessary approval are submitted up to January 31, 2004, and (v) All time loans with agreements executed up to January 31, 2004. However, if the pricing is renegotiated, these loans will be benchmarked to KIBOR.

The Chairman, Banking Credit and Finance Committee of FPCCI, leading a four member delegation of KCCI and FPCCI, had a meeting with the senior officials of SBP on 30th January 2004. He said that the Federation and the Chambers have appreciated the SBP efforts to introduce KIBOR, which was a long awaited demand of the business community. He suggested to the SBP that there should be a minimum and maximum range of spread or cushion above KIBOR for the banks, depending on the intermediary or overhead cost of the banks and customer's profile. He also drew attention of SBP to apply KIBOR on long-term loans. The businessmen expressed reservations about the manipulation of KIBOR by the commercial banks. If there is no such cap, the banks might misuse KIBOR by adding very wide spread chargeable to their customers, killing the true spirit of the scheme. Earlier the Chairman, Banking & Insurance Sub-Committee of KCCI in a press release had called upon the SBP to convene an urgent meeting of businessmen so that the business community, the main stakeholder, may express their views on KIBOR as a valid reference rate for corporate lending.



The benchmarking of KIBOR is considered a major development in the financial market with lasting beneficial impact on corporate lending practices; besides influencing the deposit rates used by the banks to compensate different classes of depositors. Through spread or cushion over KIBOR the banks would endeavour to recover all the elements of cost of corporate lending including the credit risk for transactions with different borrowers. The corporate borrowers are now expected to be more concerned about their corporate image particularly their loan repayment performance, which would surely affect the spread over KIBOR. Generally, the lower the credit rating of the borrowers the higher would be the spread over KIBOR. Also, the longer the average maturity there would be higher spread over KIBOR. The paper is an attempt to discuss critical aspects in more detail and offer suggestions for facilitating the introduction of KIBRO as a benchmark.

The determination of the spread over KIBOR or for that matter the range of minimum and maximum spread over KIBOR would not be an easy task. Many of the banks in Pakistan are said to be earning abnormally high intermediation cost or spread over KIBOR, generally in the range of 5 to 9% on annual basis. One would instantaneously call it usurious. However, in Pakistani conditions where 95% loan recovery is rarely achieved by some of the banks, such high spread might not be unjustified. Even if a particular bank specifies spread over KIBOR at 9 % average on all loans and succeeds in recovering 95% of the loans due and the interest thereon, major portion of the spread would be consumed in making up for the 5% loss both of principal and the interest. In addition, the bank would also be recovering their operating cost which might be between 1 to 2% of total assets. On pre-tax profits the bank are required to pay to the government income taxes which might range about 40%. On this basis, the bank might be making about 1% net profit on assets. However, in case loan recovery falls below 95% or the spread over KIBOR is reduced substantially below 9%, the banks may go in red.

The spread at 9% over KIBOR, whatever the justification, would not be sustainable. One could argue that the credit risk element used in the spread might be determined based on future prospects of debt-servicing and not on the basis of past experience when loan losses were high. This situation particularly for the Pakistani public sector banks and DFIs would be further complicated when the foreign banks operating in Pakistan might offer corporate loans with spread of say 250 basis points or 2.50% over KIBOR as these banks deal with only highly credible clients and their loan losses in the past were minimal. Therefore, most of the local banks shall have to considerably improve their loaning practices and procedures. Now they shall have to rank the credibility and debt-servicing capability of different borrowers and set the spread over KIBOR accordingly. This point is elaborated using a few hypothetical examples.

ABC and XYZ two industrial enterprises approach Pakbank for Rs 100 million loans each for six months. ABC and XYZ have profitable operations. ABC is a public limited company listed on the Karachi Stock Exchange, where its shares are actively traded at a premium. XYZ however is a private limited company owned by a group of industries, none of which is a public limited company. Pakbank is likely to quote a higher spread say 350 basis points over KIBOR to XYZ as against a relatively lower spread say 250 basis points over KIBOR quoted to ABC. Pakbank would perceive ABC as a relatively lower credit risk as compared to XYZ. The owners of XYZ might realize that they are being charged higher spread due to corporate status and family management.

ABC is a highly profitable public company whereas XYZ is marginally profitable. ABC has been recently rated as AA+ by the Rating Agency on the approved list of the SBP. Both happen to be public limited companies listed on the Karachi Stock Exchange. Shares of ABC are actively traded at high premium whereas trading of XYZ shares is not so active and quotations are around par value. ABC and XYZ approach Pakbank for three month facility of Rs 200 million. Pakbank might be very quick in giving a quote to ABC whereas it might delay a quote for XYZ. ABC might be asked a spread over KIBOR at 250 basis points as against 350 basis points for XYZ. Chances are that for XYZ, Pakbank might also prescribe stricter loan conditions. XYZ would be wise to take steps to improve its profitability and corporate image for borrowing at a much lower cost.

ABC and XYZ approach Pakbank for a loan facility of Rs 300 million for a period of six months. ABC with a credit rating of AA+ is listed on all the three stock exchanges of the country. Its operations are highly profitable and the shares are traded at high premium. As against, XYZ is a loss-making private limited company, reported to be in litigation with one of its existing creditors. In the circumstances, Pakbank might deliver an offer letter with spread say around 150 basis points over KIBOR to ABC. For XYZ, Pakbank might indefinitely delay making an offer or simply refuse to entertain the request on some pretext. Pakbank is not likely to quote very high spread to XYZ. The risk profile of XYZ will simply drive Pakbank away from making any business relationship.

The above examples depict the high cost of borrowings for companies that are not profitable or well-known. The corporate borrowers would better reduce their cost of production; improve productivity and profitability to be able to borrow at a lower spread. Intermediation cost or spread over KIBOR can be brought down if the corporate borrowers show better performance by maintaining repayment nearly 100% and the banks by reducing their operating costs. In practice, the banks shall also have to improve their credit risk analysis capabilities and stay competitive in the market where large foreign banks are also operating.



Pakbank is not alone in the financial market as there are possibly 15-20 other banks and DFIs offering similar loan facilities to the corporate sector. All financial institutions would be vying for establishing business relationships with companies having better credit ratings, profitability and corporate image. Good borrowers wish to deal with banks offering relatively cheaper credits and better services. The desire to attract good business with credible customers would keep major banks on their toes by cutting costs, improving efficiency and quality of their service. KIBOR is expected to be used more by the foreign banks operating in Pakistan. In their world-wide operations they are mostly using benchmarks such as LIBOR and proper systems are already in place. The local banks should expect tough competition for attracting credible customers.

Spread over KIBOR would be adjusted to some extent on the possibility of other income from the borrowers. The banks cultivate business relationships with credible companies of well-known business groups in the hope of earning fee income from export/import trade or other fees for the advisory service in areas such as issuing additional capital, acquisition of units being privatised or merger of two or more companies. These assignments are given more on the basis of confidence in the team of officials deputed by the banks and past performance for such services provided to the company or the group. Local banks might face severe competition in this regard if they ignore to put experienced and capable hands on the job.

Under WTO arrangements, all quotas are scheduled to end from January 2005. Pakistani businesses would be under pressure to maintain their competitiveness internationally. In order to reduce their cost of production, they might approach the SBP for lower spread over KIBOR and for cheaper utilities. This process should not be adversely affecting the local banks and utilities. In the context of KIBOR, the GOP/ the SBP might also consider the following:

1- The contributor banks now numbering about 20 are proposed to be short-listed to 12 banks; the average of quotes by these will be the KIBOR. Even 12 are high and it might be reduced further. Moreover, for the purpose of KIBOR only those banks might be included which do not discourage small depositors from maintaining accounts with them; and

2- The businessmen in a meeting with the SBP officials expressed reservations about possible manipulation of KIBOR by the commercial banks and to avoid that they proposed fixing of the range for minimum and maximum spread over KIBOR. The GOP/the SBP might in due course consider and specify the minimum and the maximum levels of spread over KIBOR for different maturities of financial products and/or for different sectors. It is however felt that at present there is not enough empirical data on loans and borrowers to support a proper determination. The banks might be asked their views in this regard, supported by their past data including profits, income from loans as compared to total income and actual interest rates charged on loans over and above the weighted average cost of deposits. The corporate borrowers might also be required for providing actual data in support of their suggestions. The SBP might provide a forum for constructive debate to all stakeholders for determining spread over KIBOR for different financial products/maturities in a transparent, fair and equitable manner.