Impact of Prudential Regulation


Presence of more vivid rules is likely to lead to a revived interest of retail investors in equities market at the back of institutional support

Dec 08 - 14, 2003

The latest Prudential Regulations regarding investment of financial institutions in shares of listed companies resulted in erosion of the KSE-100 index. However, after a meeting of leading brokers from Karachi with Governor of State Bank of Pakistan (SBP), certain amendments were announced. Though, some confusion still prevails general perception is that in the presence of more vivid rules is likely to lead to a revived interest of retail investors in equities market at the back of institutional support

It is necessary to keep the fact in mind that there is an underlying correlation between the Prudential Regulations and the stock exchanges due to the restriction imposed by the central bank on investments by banks and DFIs in equities. The regulation implied that the Banks/DFIs (Development Financial Institutions including Pak Kuwait Investment Company, Saudi Pak Industrial and Agricultural Investment Company, Pak Libya Holding Company, Pak Oman Investment Company and other financial couldn't make investments in shares in excess of 20% of their own equity. But, for Islamic banks this requirement was relaxed up to 35% of the equity. The regulation further stipulated that investment in a single company's scrip should be limited to 5% of the equity of the financial institution. If more than 5% of the shares of a single company are acquired owing to the underwriting commitment, the institution would have to offload it with in a period of three months.

However, the latest amendments issued on November 10, 2003 exempts DFIs (that do not mobilize deposits or raise funds through Certificates of Investment (COIs) from general public/individuals) from this condition. Those institutions, which mobilize deposits or COIs from the general public, would have to bring their investments up to 35% of their equities. Furthermore, investment of banks in shares of Public Sector Enterprises and autonomous bodies would also not be counted towards the ceiling of 20%. The valuation of banks' portfolio would be made at cost basis for the said purpose. In addition, according to the news reports, the SBP governor had also assured the delegation that the banks that would be exceeding the above limit would be given a two-year time period as compared to the one-year time limit mentioned in the regulation.

The relaxation is very genial and obliterates the threat looming large on the future outlook of our stock market. It is a well-known fact that high liquidity provides a major thrust for the upward movement of the stock market and commercial banks and DFIs been providing the market with this support. Hence, exempting DFIs and investment in shares of PSE leaves a healthy margin with the financial institutions to continue with their contribution in the capital market growth of the country. Furthermore, in the presence of more vivid rules, it is likely that the confidence of not only the financial institutions would be restored in the securities system but would also lead to a revived interest from the retail investors at the back of institutional support.

The analysts are still looking at the potential impact of selling by banks and DFIs on the stock exchange. The reality remains, even if one assumes the excess not to be huge, some of the banks may resort to selling to avoid non-compliance. The clarification of SBP to quantify the investments on the basis of cost as compared to the current market value is also a lot more practical. Had it been on the basis of market value, it would have meant an indirect cap to the price movements of individual stocks as well as the index as whenever the stock prices had increased, the banks had resorted to selling. The latest move was also expected to have a positive impact on the IPO of Oil and Gas Development Company. The lack of interest of financial institutions to invest further in the equities might have affected the response to this important transaction as well as to the series of divestment scheduled by the Privatization Commission in the upcoming quarter.

A growing conviction is that stock markets are not "casinos" where players come to place bets. Stock markets in a developing country provide services to the non-financial economy that are crucial for long-term economic development. Stock markets tend to complement and not replace bank lending and bond issues. It goes without saying that if regulations are imposed without grossly providing shocking disturbances to the smooth flow of the system, these always turn out to be more fruitful. We also believe that such consideration should also be taken in while phasing out the Carry Over Transaction COT (or badla) system from the local stock exchanges. Given the important role of stock market, policy makers are right in considering reducing impediments to its developments.

The writer is Head of Research at Capital One Equities