THE CAPITAL MARKET REFORMS

The objectives of reforms were to bring in good governance and corporate culture

From SHAMIM AHMED RIZVI
Islamabad
June 24 - 30, 2002

That the capital market in Pakistan has stabilized is amply proved from the fact that despite passing through a sequence of descriptive events within and outside the country it has not only survived but has, in fact, improved. The stock market have successfully absorbed the constants shocks during the last over nine months and which are still continuing and emerged victorious showing its depth, grit and potential.

"This is indeed a source of satisfaction to note that despite mounting tensions between India and Pakistan, deteriorating law and order situation and the fall out of political ups and downs in the region, the stock market registered an increase of about 40 per cent in equity index", commented an stock market analyst adding that credit mostly go to Securities and Exchange Commission of Pakistan (SECP) which initiated and vigorously carried out various reforms during the last 2 years to stabilize the stock market in Pakistan. Investor's confidence has been regained by making market transparent and safe.

When approached by this correspondent for comments, the Chairman, SECP, Mr. Khalid A. Mirza said "I am thankful to God that the position of the Commission has been vindicated". We faced very tough opposition when we initiated the reform programme", he added.

Explaining the background of reforms he said "In April, 2000, when I took over as Chairman, SECP, there were essentially two issues affecting investor confidence:"

First, very little faith in the integrity of the market, in the price discovery process, in the trade settlement process the fact that the stock exchanges were basically run by stock brokers, for stock brokers, appeared to be at the root of the problem. Second, very little faith as to whether the companies listed were being managed for the benefit of all stakeholders and were actually sharing the "goodies" with all concerned, particularly portfolio investors. The perception was that there was no transparency, the majority owners were "hogging" all the benefits, and investor got nothing.

"Also, within a couple of months of my arrival, there was a stock exchange crisis essentially a settlement crisis caused by excessive overtrading and weak risk management at the stock exchanges. This gave an ideal opportunity to implement a reform agenda."

"We first addressed governance and risk management issues at the stock exchanges and took following steps:

- Independent "professional" Chief Executives were installed at the Stock Exchanges + 40% independent directors;

- Margin requirements strengthened now going on to "value-at-risk" basis;

- capital adequacy limits imposed on broker exposure;

- net capital requirements redefined and strengthened;

- practice of "blank sales" replaced by generally accepted and carefully regulated "short-selling";

- appropriate circuit breakers installed;

- system of disclosed trading abolished;

- T+3 system implemented in place of the archaic weekly settlement cycle;

- an automated National Clearing and Settlement System has been developed and is under active implementation this, together with the already established Central Depository System, represents a major step to modernize the market; and

- direct regulatory nexus established between the brokerage community and the regulator by requiring all brokers to register with the SECP and requiring all brokers to adhere to a Code of Conduct established under the Brokers Registration Rules.

Now we have initiated the Second phase of reforms agenda is to ensure good governance of the corporate sector and transparent management especially of audit and accounts of the listed companies, SECP has already taken the following steps

  • Companies have been asked to publish quarterly financial reports

  • A Code of Corporate Governance has been enforced

  • To ensure reliable accounting statements and audits, we have:

(a) required listed companies to facilitate quality control reviews of their auditors by permitting the release of audit papers for this purpose;

(b) directed listed companies not to engage their auditors to perform other services;

(c) required mandatory rotation of auditors after five years implemented with forbearance up to December, 2003; and

(d) required that an auditor found guilty of professional misconduct not to audit listed companies for 3 years.

To assess the situation from independent sources PAGE formulated the following four questions and requested Mr. Omar Iqbal Pasha, a broker/Chairman of Islamabad Stock Exchange and Mr. Samir Ahmed, a non-broker independent Managing Director of Lahore Stock Exchange.

Following are the questions and answers received by the two gentlemen respectively

1. SECP claims that the numerous measures it has taken to reform the capital market have left a very positive impact on it. What are your comments?

OMAR IQBAL PASHA:

The Chairman of the Islamabad Stock Exchange, Mr. Omar Iqbal Pasha, was highly appreciative of the reforms carried out by the SECP, which had helped a lot in stabilizing the Capital Market in Pakistan and building the confidence of the investors.

Mr. Pasha, who has been associated with ISE for the last many years as Director and Vice Chairman, appeared pro-transparency, contrary to the traditional secretive behavior of the brokers community. He strongly supported the SECP reforms that had opened the bourses governance to the vigil from outside in the form of non-broker directors and appointment of outside professionals as an independent Managing Director.

Replying to question number one he said that what has been achieved by the SECP during the last 30 months to improve the working of capital market in Pakistan outweighs the efforts during the preceding 4 decades.

Recounting the reform measures, Mr. Pasha said, at the behest of Asian Development Bank, SECP initiated a series of reforms with the view to strengthen its role as a regulator of the capital market as well as to put the country's securities market on sound footing. These reforms included, among other things, the following:

  • 1. Restructuring of the Governing Board and appointment of professional Managing Director by the stock exchanges.

  • 2. Enhancement in Net Capital Balance.

  • 3. Introduction of Capital Adequacy.

  • 4. Ban on Blank Short Selling

  • 5. Introduction of T+3 trading and settlement system.

  • 6. Prohibition of Free Exposure Limit.

SAMIR AHMED:

The over all objectives of the above reforms have been: to bring in good governance, corporate culture, transparency in the affairs/operations of the stock exchanges; to curb the speculative trading which up till recently was rampant in the market; to strengthen the risk management regime of the stock exchanges in order to safeguard the interest of investors and the Institution; and over and above to bring the existing trading system at par with the developed countries by replacing the balance order settlement system with T+3 trading and settlement system. Most of these reforms have already been implemented. As a result, today's capital market in Pakistan is more stabilized, transparent and secure, enjoying the confidence of investors.

The various measures taken by the SECP have had a significant effect on the capital markets. At the stock exchanges' level, the most critical area was on the corporate governance side. It was necessary that the management of the Exchanges be separated from the membership of the Exchanges. This separation is necessary to remove the conflict the interest, which arises when members also manage the affairs of the Exchange.

This has been achieved in different degrees at the three Stock Exchanges. Lahore Stock Exchange (LSE) has taken the lead by achieving a clear separation and inducting an independent professional non-member Managing Director, who has all the operational powers in running the affairs of the Stock Exchange. One of the main areas in which this has separation had an impact, is the issue of investors' complaints. There used to be a feeling among the investors that their interests were not adequately looked after. At LSE in the current financial year, more than 150 investors' claims amount to Rs. 25 million have been paid of.

Another area, where a major impact has been made, is in ensuring that all members are complying with the Rules and Regulations of the Exchanges and no exceptions are made for anyone. This has resulted in enforcement of Rules regarding capital adequacy requirement for brokers, and also in the taking of adequate exposure margins from all trading members, thus reducing the risk being borne by the clearing house of the Exchange.

LSE has implemented the Trade Risk Filter (TRF), which is a pre-trade verification feature in our software. The TRF automatically ensures that no trading members are able to exceed their trading limits, and in the process put the Exchange's Clearing House at risk.

Another major reform was the induction of the T+3 Rolling settlement System. This has further reduced the risk by reducing the period between trading and settlement to 3 days, which is in line with international standards.

The badla market has been identified as a potential risk factor and the Exchange have recently started taking margins from brokers for all their badla transactions. LSE has gone a step further than other Exchanges and limited the badla to only 35 of the most liquid scrips.

2. Now the SECP, in its second phase of reforms, is concentrating on improving corporate governance. What are your views on this ongoing exercise? How is it going to help the corporate sector?

OMAR IQBAL PASHA:

The ongoing efforts of the SECP to ensure good corporate governance of international standard are most commendable. This is the most important step taken towards development of capital market. It is encouraging to note that despite opposition from certain quarters SECP is pursuing the implementation of the Code of Corporate Governance vigorously. An improved governance of the corporate sector will attract more capital lending to development of capital market. Even those who are opposing these reforms now will soon realize that it would be in the interest of all stakeholders.

SAMIR AHMED:

Significant progress has been made in the corporate governance of the Stock Exchanges in the last two years. The next phase seeks to improve the corporate governance of the listed companies. The Code of Corporate Governance was incorporated in the listed companies. The Code of Corporate Governance was incorporated in the Listing Regulations of the three stock exchanges in April 2002. The Code is a major step forward for the betterment of the capital markets as it will ensure that the interests of all stakeholders especially the minority shareholders are adequately looked after. While there are a large number of well managed companies, which have been paying good returns to their investors, there is a much larger number of companies, which have failed in this regard. The Code by specifying requirement like Audit Committee, Internal Audit function and also qualification and eligibility of key corporate officials like the Chief Financial Officer and Company secretary, will have a positive impact on the working of company. The Code also puts responsibility for compliance with the Board of Directors and External Auditors, which will further ensure that companies are managing the interests of all stakeholders.

3. Non-Banking Finance Institutions are going to be under the regulatory purview of SECP by next month. How will it help in developing this sector?

OMAR IQBAL PASHA:

The SECP has fully demonstrated its capacity by reforming the capital market. NBFIs are directly linked with" the formation of capital and capital market activities. The decision of the government to put NBFIs under the regulatory purview of SECP is well thought out. I have no doubt in my mind that it would prove beneficial for national economy as well as to the stakeholders.

SAMIR AHMED:

The SECP is in the process of bringing out a detailed regulatory framework for the NBFIs, which will govern the working of various types of organizations like Investment Banks, Mutual Funds and leasing companies etc. Proper regulatory framework and strong enforcement should ensure that these companies are managed for the purpose, for which they were created, and also functioning with adequate capital and internal controls. The financial sector is very sensitive and it is necessary that all organizations are managed in a way that they do not cause any systematic risk to the financial system.

4. Do you feel that continuity of these reforms must be ensured to reach a logical end and to reap its full dividends?

OMAR IQBAL PASHA:

In my opinion, continuity of these reforms is necessary. Reform is continuous and ongoing process. I however feel that we should follow a slow and steady process. The SECP has already initiated a number of measures in different direction. Now it should relax for some time and instead of introducing new regulatory measures it should monitor the implementation and consolidation of the reform measures already initiated.

SAMIR AHMED:

While significant progress has been made in the last couple of years, there is still a long way to go before we can claim that we are at par with international standards. In any case, reform is a continuous and ongoing process, which never ends. Our markets and our regulators have to be alive to the changing circumstances. It is necessary that the reforms, which have been initiated are consolidated and improved upon for the next few years to enable them to take root in our country. Any back tracking or slippage in the reforms process, will have a very negative impact on the economy as a whole.