The borrowers normally have little choice but to agree to the conditionalities

Jan 10 - 16, 2005



Loans and credit have been around since times immemorial. A farmer might have loaned a measure of grains for consumption by the family of a sick neighbour or for use by him as seed to grow crop in the coming season. In those days perhaps a promise to return the grain at next harvest was all that the creditor could get and probably it worked well. Barter trade came handy in many such situations and credit risk was avoided. The needy farmer could exchange his goat or cow for a few measures of the grain for the family. The advent of cash as medium of exchange and adopting of different vocations by the people laid the foundation of primitive trade and industry. The craftsman might have borrowed from family and friends to arrange the tools and the place of business, if his own savings were insufficient. Credit was possible as the borrower, his family and property were known and his enterprise was considered promising. This could be among the original techniques for credit risk management. The craftsmen such as ironsmith, weaver or carpenter would be paid in agricultural produce or cash for their goods and services or they would get a promise for settlement at the time of next harvest. This process formed the credit chain and helped in promoting economic activities.

These days, a large number of lenders are vying for profitable opportunities to deploy the funds. A local lender can be an individual, a money lender, a cooperative, a bank, a DFI, the central bank and the provincial or federal government. Foreign and international lenders include the governments, international financial institutions (IFIs) such as the World Bank, ADB, IFC, IMF, and commercial banks. All lenders consciously try to minimize the credit risk. They determine the loan amount and prescribe interest rate, security and other conditions when the borrowers approach them for meeting their needs. The borrowers normally have little choice but to agree to the conditionalities. However, when liquidity is easy, the banks change their tactics and market schemes to attract more borrowers. Foreign governments for promoting sale of locally manufactured goods to needy developing countries, allow buyers or suppliers credits coupled with risk insurance to the local banks or the manufacturers financing such exports. The fee for such insurance is to the borrower's account. Such credits are mostly tied i.e. procurement has to be from the creditor country. Machinery prices are generally higher for the same or better goods, if purchased on cash.

The borrowers are numerous in all countries, perhaps more in developed countries where credit is a way of life. Individuals are by far the largest number of borrowers. Different individuals, businesses, industrial entities, municipalities or governments need small, medium or large loans depending on their respective needs. Microcredit to jobless poor is more popular in the context of poverty alleviation. The small loan has the potential to give hope to the jobless poor by enabling him to earn a living for the family. Many such loans are without a physical asset as security but recovery rates are quite high. Slightly bigger loans are made for promoting cottage industries or small businesses after scrutiny of capital, capacity and character of the borrower. These loans are properly secured and documented. For financing establishment of gross-root industrial plants or for expansion of small, medium or large industries, the loan amounts are much bigger. Commensurate with the financial exposure, the banks use elaborate appraisal methods including credit risk management techniques and so are the security and documentation. These loans are made as per bank guidelines and in compliance with the Prudential Regulations prescribed by SBP.

Most people borrow from family, friends or money lenders but a large number also borrow from proper lending institutions. Private money lenders lend mostly to individuals at high interest rates and are very strict in loan recovery. Many businessmen and traders, to protect their personal or family properties from the reach of the creditors, incorporate limited liability companies for owning the business / industry. The lending institutions with large loans to sole proprietorships or partnerships require the borrowers to incorporate limited liability companies and to also provide personal repayment guarantees in addition to usual securities. Security is generally negotiable but minimum security has to be there as per the Prudential Guidelines of the State Bank of Pakistan (SBP). The borrowers do not always succeed in keeping their overall borrowing cost at the minimum.

The provincial governments and large public sector corporations are given loans by IFIs such as the World Bank, KfW and ADB for development or industrial purposes. In most cases the borrower would be the Government of Pakistan, which would pass on the loans to the respective provincial government or the corporations operating under different ministries or departments. More often these loans are passed on the same terms as prescribed by the IFIs but sometimes the terms particularly interest rates are changed, making the loans costlier for the ultimate borrowers. There is space for improvement in the borrowing from IFIs. Lending is said to be an art but borrowing is not any less particularly when it comes to selection of appropriate lenders and keeping low the overall cost of borrowing. Expertise might be developed within the government, municipalities and corporations for this important function.

The loans can be for productive purposes such as purchase of tools of trade or for consumption such as marriage of a child. Consumption or consumer durable loans are repaid from income accruing to the individual in the form of salary or property rent or sale of some assets including encashment of saving certificates. Loans taken for productive purposes by the individuals or corporate entities are perceived better by the creditors as they increases cash generation capability of the borrower and have better chance of repayment. However, some of the loans turn bad and the creditors are obliged to foreclose security or start recovery proceedings through the courts.

The banks provide short, medium and long-term loans. Short-term loans could be to the individuals for personal reasons or for working capital to trade or industry. An industrial borrower might use loan proceeds to buy raw material for processing in the factory to manufacture a finished product in a few weeks or months. The finished goods will be sold on cash or credit. On receipt of cash from the customers, the bank loans will be repaid, with interest. The credit is made by the bank according to the cash cycle of the particular industry. Medium and long term loans are generally for setting up industry, for expansion purposes or for building infrastructure projects. Repayment of the loan is over a number of years but within the economic life of the project. Sometimes, loans are made for an interim period to be adjusted from funds due under some other long term financing arrangement. These loans are known as mezzanine financing and often serve useful purpose. Small projects can be funded entirely by equity but debt becomes inevitable in most cases when the projects are bigger. Leverage helps in improving working capital and increasing profitability potential. There has to be a proper balance between loan and equity.



The banks lend only to suitable borrowers as perceived by them. For management of credit and other risks, the banks employ a number of screening techniques. The project parameters technical, marketing and financial are appraised systematically and so are the promoters, their creditworthiness and financial means, possible risks to repayment and mitigates thereof in the prevailing environment. Both subjective and objective tests are employed to determine project viability and debt servicing potential. In addition, the loans are documented and adequately secured before any disbursement is considered. Bank officers who handle processing of loans are usually trained and in most cases, only make recommendations. The actual decision for financing is that of the owners or of the board of directors. The project appraisal and risk management techniques are being continuously improved. Modern methods including credit scoring are being mixed with traditional precautions and security. The commercial banks also advertise small loan schemes with initial screening criteria such as minimum monthly salary of the borrower or the minimum landholding of the farmer. This way the processing time is reduced drastically and disbursements is made in a short time. SBP might look into all these schemes and the underlying agreements.

Loans can be in Pak Rupees or in foreign currencies such as US Dollar, German Mark, French Franc or Euro. Foreign loans might be out of credit lines extended to local banks by IFIs or out of foreign currency deposits with the banks. These loans involve exchange risk, which might be covered provided the cost to the borrower is reasonable. In Pakistan, SBP used to provide cover to the borrowers. Local and foreign loans can be on fixed or variable rates of interest. In each case, the borrowers and the lenders are exposed to interest rate risks. The local currency loans these days are mostly linked to KIBOR over which some margin is charged depending upon the risk perception. Some of the borrowers raise hue and cry when margin is in the region of 5% over KIBOR as against 0.50 to 2.50% range quoted mostly by the foreign banks to their selected borrowers. The borrowers might first look at and improve their credit standing, as perceived by the lenders.

More infrastructure projects, in line with the government efforts for economic growth and people's welfare, might be implemented in the coming days, partly financed through bank loans. Such projects are highly capital intensive and must be appraised properly to mitigate risks and to determine whether cash generation will be sufficient to repay debts and produce a satisfactory rate of return. Often, large loans would necessitate financing by more than one bank under consortium or syndication arrangements. In such cases, participating banks may jointly appraise the project using in-house expertise or get the project appraised through independent reputable consultants. Moreover, the banks might clearly delineate procedure for monitoring use of funds and assuring value for money in all purchases. In case the projects are financed under BOT or other similar facilities, the banks must have experienced teams for handling Project Finance under limited or non-recourse financing. This is a relatively new difficult technique based on a large number of inter-locked agreements and might be handled with care, especially by the district and provincial governments.

Loaning on overall basis is a profitable function, despite there being some non-performing loans (NPLs) or bad loans. NPLs adversely affect financial health, profitability and survival of the creditor institutions. If any creditor has relatively high NPLs, it has first to look at its policies for project appraisal, loan approval, disbursement and monitoring. The teams handling these functions might be properly motivated and trained. The creditor might jealously watch the quality of loan portfolio and take timely remedial measures. These days the banks are finding new ways to restructure stuck-up consumer loans including credit card over-dues. They are inviting the borrowers to switch the short-term loans to medium or long-term loans with lower rate of interest offered as an incentive. Naturally, there would be new documentation and possibly better security. SBP is urged to ensure Truth in Lending and fairness to the borrowers.

It is said that there will be no more of IMF loans and conditionalities. The country might be raising funds from the market as well as from other IFIs. In fact, these IFIs are offering large foreign currency loans for meeting the costs of implementation of reforms in a number of government sectors. Only local currency funds are involved in reforms. If loans from IFIs are availed for the purpose, our foreign reserves would rise so would our outstanding foreign borrowings and debt servicing. We have to a large extent the expertise available locally for taking up and implementing the needed reforms. The local experts might be associated with the foreign IFI experts in large numbers in the handling of the reform projects in different sectors. The district, city, provincial and federal governments might develop expertise for mobilization foreign funds at competitive rates from international markets as well as the IFIs with which we have long association.