With leases being extended largely to small enterprises, leasing companies are crucially important for expanding the productive base, and the pace of overall economic growth in developing economies

July 28 - Aug 03, 2003

The roles of capital markets, banks, and non-bank intermediaries are complementary. All exert a positive influence on economic development and growth but accelerating and promoting the development of leasing companies an increasingly important part of financial systems in developing countries is far more important. These institutions finance small, up-coming businesses that will take centre-stage in future economic growth, and in alleviating poverty.

With leases being extended largely to small enterprises, leasing companies are crucially important for expanding the productive base, and the pace of overall economic growth in developing economies. As the spectre of poverty begins to haunt more developing and transition economies, enhancing the role of these institutions will become more important for alleviating poverty on a sustainable basis. In this context, the point to note is that institutions for extending loans to small businesses must not be high intermediation cost and bureaucracy-ridden giants such as the large commercial banks. Pakistan's leasing companies fulfill these conditions and deserve to be supported through good regulation.

Pakistan's leasing companies offer cost-effective services and are therefore gaining importance as businesses focus their attention on cutting the overall cost of their borrowing relationships. In emerging economies, between one-sixth to one-third of the fixed asset-base is now financed by leasing companies because they are better suited to meet asset acquisition needs of businesses, and fill the dis-intermediation gap that usually prevails in developing economies. Pakistan is one of them, though recent changes in regulation that permit banks to share the leasing market with leasing companies, have tended make the playing field uneven for this vital sub-sector of the financial services sector.

In site thereof (which created serious problems this sector in terms of sustaining its growth and profitability), this sector has achieved significant successes, especially in the last three challenging years. It has undergone a process of equity expansion, mergers, and consolidation because the sector is now seen as a substitute for the vanishing breed of Development Finance Institutions (DFls). Leasing companies (rather than banks), are increasingly being called upon to cater to the fixed capital formation needs of big business. The sector now accounts for nearly Rs. 15 billion of annual capital asset formation, and innovations such as customised leases with staggered re-payment schedules, floating rate leases, and now operating leases as well.

The diminishing role of DFls increased the demand for large-ticket leasing, which created bigger but more complex business opportunities accompanied by the equally complex issue of raising large financial resources. Leasing companies responded to this challenge through more innovations customised syndicated leases, Certificates of Investment (COIs), and Term Finance Certificate floatation (TFCs) to meet specific lessee needs and raise large amounts of both short and long-term funds. These initiatives deserve appreciation by all concerned, especially the government, which is trying hard to promote investment in all sectors including the small and medium scale sectors as well as the large end of the industrial sector.

By raising market funds through COIs and TFCs, the leasing sector has been conducive to the expansion of another vitally important activity; expansion of the commercial paper and bond markets. A number of TFCs floated by leasing companies are being traded on stock exchanges. On the one hand it has helped to mobilized resources, and on the other, it has enhanced the choice for savers and investors manifold in an environment of rapidly falling returns on all kinds of debt paper, both public and private, frustrating the ordinary saver, especially the poor, uncared for pensioners.

Flotation of TFCs has made a significant contribution in channelling public savings for capital formation something that Pakistan wasn't able to do in the past due to the virtual non-existence of a corporate bond market to provide ready liquidity to the investors. It has expanded the options that the industry now has for raising financial resources more efficiently. Partly, in the past, this shortcoming had also prevented efficient financial intermediation, and was responsible for the high financial costs of Pakistan's corporate sector. Listing of an increasing number of bonds on the stock exchanges would speedup the development of an active secondary market for corporate bonds.

In a large measure this reform will have to do with devising less complex steps for collateralising and re-possession of borrower assets. It may surprise some of us that in many East European countries (centralized economies until recently) existing civil law was sufficient to draft watertight lease agreements enabling leasing companies to enforce their rights without a special law for protecting those rights. This area has not been addressed as effectively as it aught to be. In spite of the recent changes in foreclosure laws, leasing companies still face problems in re-possessing assets.

In spite of its undeniable achievements, prospects of the leasing sector are sometimes placed at risk by government and regulatory action. For instance, last year, the CBR withdrew this sector's critical cost advantage (tax-deductible initial depreciation allowance on used machinery). It was surprising because CBR knew very well that Pakistan's textile sector needed huge financial support for replacing its aging plant and equipment with imported used equipment to prepare itself for the challenges posed by the impending changes in WTO regime effective January 2005. The allowance was restored after a year-long exercise in convincing the CBR about the crucial importance of this relaxation in supporting the industry's drive of badly needed BMR.

In spite of such unfriendly developments that tend to stop this sector in its tracks, big ticket leasing is continuing at a rapid pace, and is being met by the leasing sector. But what Pakistan needs badly is to develop its small and medium scale industrial base to control unemployment and poverty. In this context, it is important to note that, firstly, institutions lending to small businesses must be cost-efficient if they are to lend at rates that allow small borrowers to earn progressively higher profits that support their eventual expansion into economically viable units. Secondly, these institutions need to focus very closely on each borrower to keep the borrowers on track for becoming viable and self-sustainable. Finally, only smaller, more efficient lending institutions can effectively provide the crucial combination of low intermediation cost and close customer-business monitoring.

Apparently, regulators don't give adequate credence to the fact that since leasing companies finance specific assets, they require less by way of complex bureaucratic infrastructure compared to the other intermediaries. It is easier (and therefore less costly) to assess the risk associated with an asset than the creditworthiness of a firm, particularly one with a short history. These advantages render leasing companies cost-effective, which is often not the case with overly centralized bureaucracy and cost-ridden institutions like big banks to serve these needs as effectively as the smaller, leaner leasing companies. Yet, banks have been permitted to enter this field in a big way.

Regulating leasing companies is an evolving process. To a large extent, the direction it would take will depend on the way leasing companies are managed. If the sector demonstrates that it can credibly self-regulate, the need for intrusive supervision may not arise. But it requires that the leasing companies credibly manifest their consciousness of two critical risks they carry viz. credit risk and interest rate risk. Selecting manageable credit risk is a function of the choices they exercise in spreading their lease portfolios among the various sectors of the economy and lessee categories.

Regulators would be rightly concerned about the fact that as leasing companies go about building larger portfolios in an ever-expanding variety of industrial machinery, credit risk selection will assume serious dimensions, and require exhaustive investigative effort similar to that undertaken by DFls financing components of an integrated industrial project. Many such large leases have been written. Though there have been remarkably few sad experiences of such leases becoming delinquent, they stand out as reminders of the need for more focused effort in risk selection and management.

Leasing companies would be well advised to remember that besides political interference, the major factor contributing to DFI failure was faulty decision-making due to lack of investigative effort in validating the cost and sourcing of technology, and sustained availability of technical and material inputs to keep the financed plants running. Faulty decisions were rooted in inadequacy of focused and credible economic forecasts and studies on changing technology trends to establish a realistic speed of plant obsolescence. Leasing companies must guard against these risks.

In this context, another risk to be guarded against is the lack of disposal prospects for re-possessed assets. Given the weaknesses in the legal system that hinder lenders in obtaining effective possession of financed assets from defaulting borrowers, this will remain a critical yardstick in determining credit risk. Insuring leased assets not just for their value, but against the risk of their breakdown, is vital to sustaining healthy lease portfolios. This gives rise to another important risk i.e. the risk of taking inappropriately large exposures on individual insurers. This aught to be monitored closely in times of heightened market stress that places even strong insurers under severe strains.

Keeping in view the positive role it has been playing, the genuine interests of this sector need to be safeguarded by the State. An area in which the State must help leasing companies is the law relating to property ownership because these companies own the assets they allow their lessees to use, and therefore must have unquestionable legal support in repossessing those assets from defaulting lessees. The pace of legal reform is an essential ingredient for the evolution of a freer economy because, without a legal system conducive to promoting freer, yet secure markets, the aim of expanding the enterprise base and economic activity cannot be achieved.

Leasing companies should also remain conscious of the interest rate risk that arises when there is a significant mismatch between the bases on which it is build into lease rentals, and paid out on liabilities funding the leased assets. As the money market becomes more dynamic in terms of interest rate movements, leasing companies financing assets from borrowed funds will become vulnerable unless they cover their interest rate risk through appropriate hedging instruments of which few are presently traded in our markets. The marked increase in floating-rate TFCs being issued by leasing companies suggests that they are managing this risk with reasonable caution. Over time, however, this hedging arrangement may not afford the flexibility and cost efficiency demanded by increasingly competitive markets. This calls for examining other potentially useful hedging arrangements that could be institutionalised in due course of time with the concurrence of other market players.

If leasing companies can devise and install effective internal control systems to continually monitor and mitigate these risks, they will set a good example of self-regulation. But, for self-regulation to become visible, it must be institutionalised by mandatory requirements. Leasing Association of Pakistan is the forum to address these regulatory issues on a collective basis, find workable solutions thereto, and ensure their implementation by all member companies. This is the suggested route to confining official regulation to focus its attention on the more important subject of ensuring an even playing field for all players in the financial services sector. It is in the common interest of all market players.