prs for corporate finance
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Credit Risk Compliance in Corporate Finance
A Case Study on Local Commercial Banks in Pakistan
By
Group B
Ghazanfar Qureshi (0711227)
Rajesh Kumar (0711233)
Sikandar Khan (0711242)
Sumair Khatri (0711244)
Submitted to: Zaki Rashidi
Course Instructor
BBA Thesis
Fall 2010
Shaheed Zulfiqar Ali Bhutto Institute of Science & Technology (SZABIST)
90 Clifton, Karachi
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Acknowledgement
All the praise to Almighty Allah the most beneficent and merciful who gave us opportunity
and strength to compile the BBA Thesis Report on Credit Risk Compliance in Corporate
Finance.
We are thankful to SZABIST and our course instructor Mr. Zaki Rashidi who always helped
us in understanding the research patterns and through his guidance we were able to complete
with good research work. We are also thankful to advisor Mr. Shoaib Ali Khan, Mr. Ijaz-ur-
Rehman and bank professionals because of their support and encouragement, we were able to
understand and analyze different horizons of related research material.
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Declaration
We clarify that this is our own Research work. The work has not, in whole or in part, been
presented elsewhere, for assessment. Whole material has been used from other sources, it has
been properly acknowledged. If the Statement is untrue & if we are found guilty of the
plagiarism, the disciplinary action can be taken against us, as per the SZABIST Anti
Plagiarism Policy.
Group Members
Ghazanfar Qureshi
Rajesh Kumar
Sikandar Khan
Sumair Khatri
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Abstract
As it is evident from the economic trends that the banking sector has a very significant
position in the economy. From Past few years the banking sector in Pakistan is growing at
large scale and many local and multinational banks are performing at their best and
contributing a lot in the economy. Above all there is a State Bank of Pakistan and other
regulatory bodies in the country that regularly monitor the performance of these banks and
other financial institutions according to set criteria. This research highlights the lending
procedure and its compliance with prudential regulations of three different local banks.
Moreover, it is exploratory research in which the research team has evaluated the internal
lending process and its compliance with prudential regulations. The findings of the research
are based on most of secondary data and interviews that were conducted from different
banking professionals. After analyzing these banks we came to know that banks make their
policies in accordance with given Prudential Regulations given by State Bank and most of all
banks not only work in accordance with the given polices but in case if bank fails to follow
these regulations certain penalties are also imposed on them. So we can say prudential
regulations are utmost necessary and save banks from losses as some of them are discussed
in research.
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ContentsAcknowledgement............................................................................................................................2
Declaration........................................................................................................................................3
Check For Plagiarism Originality Report............................................................................................4
Abstract.............................................................................................................................................5
Chapter 1: Introduction.........................................................................................................................9
1.1 Credit...........................................................................................................................................9
1.1.1 Types of Credit.....................................................................................................................9
1.1.2 Credit Risk..........................................................................................................................10
1.2 Measuring Credit risk................................................................................................................11
1.3 Credit Risk Management...........................................................................................................11
1.3.1 History of Credit Risk Management....................................................................................12
1.3.2 Applications of credit risk management.............................................................................13
1.4 Prudential Regulations..............................................................................................................13
1.4.1 Prudential Regulations.......................................................................................................14
1.5 Credit Risk monitoring and Control...........................................................................................18
1.6 Non-Compliance in Credit Risk Management............................................................................19
1.6.1 Penalties of Non-Compliance to Prudential regulations.....................................................19
1.6.2 Factors affecting Compliance in credit Risk management..................................................21
1.7 Problem Statement...................................................................................................................22
1.8 Objectives..................................................................................................................................22
1.9 Justification...............................................................................................................................22
1.10 Limitations...............................................................................................................................22
1.11 Definition of Key terms............................................................................................................23
Chapter 2: Research Methodology......................................................................................................24
2.1 Research Design........................................................................................................................24
2.2 Procedure..................................................................................................................................24
2.3 Population.................................................................................................................................24
2.4 Sample and sampling method...................................................................................................24
2.5 Measurement/ Instrument selection........................................................................................24
2.6 Research Schedule....................................................................................................................25
Chapter 3: Literature Review..............................................................................................................26
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3.1 Introduction to Risk Management............................................................................................26
3.1.1Credit Risk Management framework..................................................................................26
3.1.2 Factors comprising credit risk management framework....................................................26
3.1.3 Component of Credit Risk Management............................................................................27
3.2 Role of credit Ratings in Credit Risk management.....................................................................28
3.2.1 Aspects of Credit Rating.....................................................................................................28
3.3 Banking Reforms in Pakistan.....................................................................................................29
3.3.1 Impacts and Implications of Banking Reforms....................................................................29
3.4 Credit Risk Management Process: How to avoid lending disasters and maximize earnings......30
3.5 SBP amendments in Prudential Regulations..............................................................................31
3.5.1 Exemptions.........................................................................................................................31
Chapter 4: Analysis..............................................................................................................................32
4.1 Lending Procedure....................................................................................................................32
4.1.1 Allied Bank Limited.............................................................................................................32
4.1.2 NIB Bank.............................................................................................................................32
4.1.3 United Bank Limited...........................................................................................................33
4.1.4 Focus areas.........................................................................................................................33
4.1.5 Customer Analysis Package................................................................................................33
4.1.6 Compliance with Lending Process given by State Bank of Pakistan....................................33
4.2 Issues in implementing prudential regulations.........................................................................34
4.2.1 Satisfaction & Challenges...................................................................................................34
4.2.2 Advantages of implanting Prudential Regulations..............................................................34
4.2.3 Disadvantages of implementing Prudential Regulations....................................................35
4.3 Exemptions................................................................................................................................35
4.4 Evaluating Credibility of Customers..........................................................................................35
4.5 Shares as Collateral...................................................................................................................36
4.5.1 Credit rating and risk involved in shares.............................................................................36
4.6 Unsecured Financing.................................................................................................................36
4.6.1 Key Finding of Unsecured Financing & Exemptions............................................................37
4.7 Optimum Current Ratio.............................................................................................................37
4.8 Monitoring Process...................................................................................................................38
4.9 Penalties imposed by State Bank in year 2008 and 2009..........................................................38
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Chapter 5: Conclusion & Recommendation........................................................................................39
5.1 Conclusion.................................................................................................................................39
5.2 Recommendations....................................................................................................................39
5.3 Areas of further research..........................................................................................................40
References......................................................................................................................................41
Appendix.........................................................................................................................................44
Questionnaire.................................................................................................................................44
Allied Bank Limited......................................................................................................................46
NIB Bank......................................................................................................................................50
United Bank Limited....................................................................................................................54
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Chapter 1: Introduction
1.1 Credit
Credit is a legal contract on which both parties agree to terms and conditions mention in the
contract there are two parties involved, one party which is known as borrower or debtor
receives resource or wealth from another party which is known as lender or creditor and
promises to repay him on a future date along with interest. In simple terms, a credit is an
agreement of deferred payments of goods bought or loan taken from other party. With the
issuance of a credit, a debt is formed. Although credit is a loan by creditor to debtor but the
second party (borrower) do not repay the first party (lender) immediately, thereby generating
a debt, instead borrower later on arranges repay of wealth or any resources to creditor.
1.1.1 Types of Credit
1. Cash credit (Hypo):- Under this Facility a credit is sanctioned against hypothecation
of the raw material or finished goods. This letter of hypothecation creates a charge
against the goods in favor of the bank but neither the possession nor ownership is
passed onto it. This type of facility is given to the reputed borrowers who have
undoubted integrity.
2. Cash credit (Pledge):- in this arrangement a credit is sanctioned against pledge of
goods or raw material. Therefore the bank has the physical possession of goods,
however the ownership, remains with the borrower. But the bank has the authority to
sell the pledged goods and recover the amount if borrower fails to repay the credit.
3. Loan against trust receipts: - This is a loan facility up to a satisfactory limit to the
traders / customers by a Bank against security of the value of the imported
merchandise (Admin, 2007).
4. Term Loan: - A bank gives credit for a specific period, which is to be repaid with an
interest under fixed schedules. The term loan may be as follow:
Short term: Up to and including 12 months.
Medium term: More than 12 months up to and including 60 months.
Long term: More than 60 months (Admin, 2007).
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5. Lease Financing: A finance lease or capital lease is a commercial arrangement
where:
the lessee (customer or borrower) will select an asset (equipment, vehicle,
software);
The lesser (finance company) will purchase that asset.
The lessee will have use of that asset during the lease.
The lessee will pay a series of rentals or installments for the use of that asset.
The lesser will recover a large part or all of the cost of the asset plus earn
interest from the rentals paid by the lessee.
The lessee has the option to acquire ownership of the asset (e.g. paying the
last rental, or bargain option purchase price).
6. Secured Overdraft: A secured overdraft (similar to a revolving line of credit) is a
mortgage that works like the credit limit on a credit card. You can use the full amount
up to your limit over and over again, paying it off as you go. The only difference is
that the overdraft must be secured against residential property.
1.1.2 Credit Risk
Credit risk is actually the possibility that the second party (borrower) will not pay back the
money or resources according to terms and conditions mentioned in the contract (Qfinance,
2009). So credit risk is possibility of debtor to default. In banking, credit risk is a major
factor when it comes to set interest rate on a loan, longer the term of loan, usually higher the
interest rate. Credit risk is usually higher when banks give loans to companies with low credit
ratings but to overcome this problem banks mostly charge high interest rates, because high
risk high returns.
1.1.2.1 Type of risk involved in credit
Following are different types of risks that involved in credit which should be rectified by
lenders:
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Default Risk:
This is most famous type of credit, whenever banks lends money to borrower there is risk
associated with it, and the risk is known as default risk which means that it may happen that
borrower is not able to pay back money at the time mention in contract due to any reason. So
banks must have to evaluate financial condition of borrower before lending him money or
any resource.
Interest Risk:
Banks also have to deal with risk of interest rate while lending money because it is a loss for
bank if interest rates fluctuate at high percentage. So banks have to be up to date to minimize
this risk. Usually banks charge high interest rates from companies whose credit ratings are
not good.
1.2 Measuring Credit risk
It is very important for a company to have measurement of credit risk in credit risk
management. There are qualitative and quantitative techniques in measuring risk present in
credit portfolios. Banks require a rating framework that may include business risk involving
industry characteristics, Competitive position and management. Also financial risk which
includes financial condition, profitability, capital structure and present and future cash flows.
1.3 Credit Risk Management
Credit risk management is a procedure that banks and other financial institutions are using to
evaluate the risk of an investor of potential loss that occurs due to non-payments from
borrowers. Credit Risk Management is used by banks to help curb the level risk involved and
to maximize the risk-adjusted rate of return through maintenance of credit risk exposure
within reasonable limits (Coen, 1999)
1.3.1 History of Credit Risk Management
History of credit risk is much older than writing. According to Hammurabi’s Code 4,000
years ago there was not any credit rule but the failure to pay a debt is considered as a crime
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that should be treated identically to theft and fraud. The code also identified the penalties for
failure of debt payment i.e. defaulter could be detained by creditor and can be sold into
slavery. As time passes many rules were made and even people wonder of these rules
because sometimes the defaulter has given death as punishment (Brown, 2004).
This began to revolutionize in mid 19th century when United State required a huge capital
investment for railroad track. Therefore, many banks, businesses and institutions were put
their effort to determine the creditworthiness of this infrastructure. This was not possible
because it require generic information about freight tonnage, costs, rates etc. After this many
scholars gave their views about its creditworthiness and other things but Braddock
Hickman’s gave quantifiable information about investor return from bonds of different credit
ratings and other characteristics but his economics led him to wrong conclusion and created a
seed of junk bond bubble, pension fund crises and the evisceration of the ratings agencies.
This situation opened the field to young innovators to work on credit risk management. This
generation contributed a lot to the field and adds their brilliant ideas in the field. These
people even trained students and inspired them for renewal of profession. For the first tine
risky debtors investors were able to acquire reliable estimates of default probability. The
ratings suggest the qualitative data that rating AAA is less risky than BB but how much that
was the question. Therefore many estimates were carried out to find quantitative solutions
and again carried out brilliantly, moreover quantitative estimates also led to many
innovations like fixed income portfolio management (Brown, 2004).
The next challenge was to estimate exposure at default. Historically lenders fell into two
groups:
1. The banks and those trade creditors who closely monitor the financial conditions and
attempted to get all money back before the default.
2. Fixed amount term lenders and trade creditors who took most of losses but save
monitoring expenses.
Over the years the situation is changing, now the important thing is not the borrower
defaulted but how much amount creditor has lent it. To estimate exposure at default, we need
to understand the future time series of probability of default, but the probability is also not a
tool we need to understand the dynamics of the process.
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Since much of work has done on credit risk management but it still requires specific
processes to understand but it is utmost sure that problem of credit risk can be solved and for
this purpose many banks and institutions have risk management departments that evaluate the
risk of default any individual/corporate (Brown, 2004).
1.3.2 Applications of credit risk management
Significant resources and sophisticated programs are used to analyze and manage risk. Some
companies run a credit risk department whose job is to assess the financial health of their
customers, and extend credit (or not) accordingly. They also use third party provided
intelligence. Companies like Standard & Poor’s, Moody's and provide such information for a
fee.
Most lenders employ their own models (credit scorecards) to rank potential and existing
customers according to risk, and then apply appropriate strategies. Credit scoring models also
form part of the framework used by banks or lending institutions grant credit to clients. For
corporate and commercial borrowers, these models generally have qualitative and
quantitative sections outlining various aspects of the risk including, but not limited to,
operating experience, management expertise, asset quality, and leverage and liquidity ratios,
respectively. Once this information has been fully reviewed by credit officers and credit
committees, the lender provides the funds subject to the terms and conditions presented
within the contract.
1.4 Prudential Regulations
Prudential Regulations is the legal framework for financial operations and it is significant in
contributing to preventing or minimizing problems in the finance sector. This is to insure that
a prudent regulatory framework has been placed to ensure safety and soundness of the
financial system while protecting the interests of the users.
Prudential Regulations are implemented and governed by SBP (State Bank of Pakistan). If a
certain entity fails to comply with them, then the State Bank penalizes the company
accordingly. Prudential Regulations were introduced in 1990 due to changes in the scope and
orientation of financial systems and the need to have more prudent regulatory framework to
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cope with changing conditions. These were put into place in 1992 and since then have been
reviewed frequently regarding areas of Corporate, SMEs and Consumers financing.
Prudential Regulations were formulated after consulting with stakeholders both internal and
external. State Bank of Pakistan gives way to suggestions and comments from stakeholders
to renew or initiate new regulations for continuous improvement and consideration. Any new
regulations completely replace the old ones which now stand withdrawn with a few
exceptions.
SBP issued the Prudential Regulations for strict compliance, however, in some cases there
are exceptions or relaxations when keeping in view the bank has given a request only after
the merits of the case have been reviewed.
1.4.1 Prudential Regulations
R-1: limit on Exposure on Single Person and Group:
Funded based exposure to any single person/entity not to exceed 20% of the bank’s
equity
Total exposure (FB+NFB) to any single person/entity not to exceed 30% of the equity
of the Bank
Funded based exposure to any group not to exceed 35%
Total exposure (FB+NFB) to any group not to exceed 50% of the equity of the bank
R-2: Limit on exposure against Contingent Liability:
Contingent Liabilities not to Exceed 10 times of the equity of the bank
R-3: Minimum Conditions of taking Exposure:
Obtain CIB report for exposure exceeding Rs. 0.5M
Record reasons and justifications while taking exposure on defaulters
Obtain audited accounts of limited companies or where exposure exceeds Rs.10M
Borrowers Basic Fact Sheet (BBFS)
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R – 4 Limit on exposure against Un-secured Financing Facilities:
Maximum unsecured financing facility to one person not to exceed Rs.0.5M
Aggregate Clean exposure of Banks not to exceed their equity
Exemptions
Export Refinance
Government Guaranteed Loans
Placements/COIs of ‘A’ rated NBFCs
R – 5: Financial Indicators and Total Exposure of the Borrower:
Total exposure (FB+NFB) of the borrower from all FIs should not exceed 10 times of
borrowers equity
Fund based exposure up to 4 times of the borrowers equity with the exception of
Leasing Companies which can borrow up to 10 times of their equity
Current Ratio 1:1 but may be relaxed in exceptional cases to 0.75:1 by the banks
Seasonal Financing may be up to 12 times of the borrowers equity
R-6: Exposure Against Shares/TFCs and Acquisition of shares:
Banks shall not take exposure against:
Their own shares/TFCs
Against non-listed TFCs or shares on non-listed companies
Against unsecured TFCs or non rated TFCs or TFCs below BBB
Exposure Prohibited:
On any person against the shares/TFCs of that person or its subsidiary
companies
Against sponsor directors’ shares of Banks/DFIs
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On any one person against shares of any commercial bank in excess of 5%
Acquisition of shares:
Banks/DFIs shall not own shares of any company in excess of 5% of their
equity
Total Investment in shares not to exceed 20% (35% for Islamic Banks) of the
equity. Investment in subsidiaries and strategic investment to be executed
DFIs not mobilizing funds from the public are exempted
10E aggregate limit for future sale/purchase
Acquisition of shares (contd.)
Banks/DFIs not to hold shares of any company in excess of 30% (as pledge,
mortgagee, owner) of paid up capital and reserves of that company or that of
Banks/DFIs
Shares to be valued at cost
Margin Requirements
30% against the shares of listed companies, to be monitored at least on
weekly basis
10% against TFCs rated A or above and 20% against TFCs rates BBB or A-
R-7: Guarantees:
All guarantees should be fully secured
R-8: Classification and Provisioning for Assets:
Time Based Criteria for the classification of Short term and Long term facilities
ST/LT *Provision
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-S/S 90 Days 25%
-D/F 180 Days 50%
- Loss One year 100%
- Trade Bills to be classified after 180 days
- Treatment of govt. guaranteed loans/Advances
* Outstanding amount less liquid asset and adjusted FSV or mortgaged/pledged assets
Subjective criteria-credit worthiness, cash flow, operations in a/c, adequacy/realizable
value of security, documentation
R-9: Assuming Obligations on behalf of NBFCs:
Bar on issuing any guarantee or letter of comfort or assume any liability in respect of
funds mobilization by NBFCs
Permission to extend against the guarantee of NBFC rated at least A
Per party limit of NBFC to be observed
Total exposure against all the guarantees of NBFC not to exceed 2.5 times of its
equity
R-10: Facilities to Private limited companies:
The requirement of obtaining personal guarantees of all the directors of private
limited companies-waived
Banks/DFIs to formulate a policy approved by their Board of Directors in this respect
R-11: Payment of Dividend:
Before Payment of Dividend
Banks/DFIs to meet MCR
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Provide for all classified assets in accordance with PRs and full satisfaction
of SBP
R-12: Monitoring:
In case of hypothecation of stocks/accounts receivables, Banks/DFIs to obtain
monthly statements from borrowers containing bank wise breakup of outstanding
advances with the total value of stock and receivables there against
R-13: Margin requirements:
Free to determine margin requirements except:
Margin requirements on shares and TFCs. (Prudential regulations, risk
management, State Bank of Pakistan)
1.5 Credit Risk monitoring and Control
Credit risk monitoring is a system that banks need to implement to enable them in monitoring
quality of credit portfolios of clients on a day to day basis and take measures to fix issues
whenever decline occurs. This system would show banks if loans are being honored as per
the terms and agreement and if the overall risk profile is within the required regulatory limits.
Establishing a system would help management to manage overall quality of the credit
portfolios and their trends. Management should lay down procedures in view of:
a) The roles and responsibilities of individuals responsible for credit risk monitoring
b) The assessment procedures and analysis techniques (for individual loans & overall
portfolio)
c) The frequency of monitoring
d) The periodic examination of collaterals and loan covenants
e) The frequency of site visits
f) The identification of any deterioration in any loan. There are also key indicators that reveal
the credit quality of a loan such as the financial position and business conditions, conduct of
accounts, loan covenants and collateral valuation. Financial position and business conditions
indicate an overall well being of the company and its present state. In conduct of accounts
the obligors account activity is monitored. The loan covenants are basically pledges that
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should be assessed and any breaches found should be addressed quickly. Collateral valuation
is when a bank reassesses the value of collaterals on a frequent basis which is subjective to
the nature of the collateral. Very frequent reassessments can take place in case of a loan
granted against shares as they are assessed for daily changes in price. In case of perishable
goods, there have to be additional precautionary measures. Securities and TCFs should be
monitored for any decline in credit rating.
1.6 Non-Compliance in Credit Risk Management
Prudential regulations are authoritative directions issued by State Bank of Pakistan to put in
place a prudent regulatory framework for ensuring safety and soundness of the financial
system besides protecting the interests of users of financial services (FAQs, State Bank of
Pakistan).Since prudential regulations benefits the financial system therefore it is an
obligation of all institutions and financial intermediateries to comply with and work
accordingly. Besides such a good set of regulations and knowing its benefits some banks
violate the regulations i.e. they delay in actions/response as suggested by inspection report of
State Bank, such an event are not acceptable by regulatory authorities and for this purpose
they charge fine on them. Following are some of prudential regulations of risk management
that banks must follow while doing transactions.
limit on Exposure on Single Person and Group
Limit on exposure against Contingent Liability
Exposure Against Shares/TFCs and Acquisition of shares
Limit on exposure against Un-secured Financing Facilities.
1.6.1 Penalties of Non-Compliance to Prudential regulations
It has been observed by State Bank that several banks are not complying with prudential
regulations; SBP had repeatedly informed these banks about the violations SBO inspection
reports. These types of violations are not acceptable from the regulatory point of view. With
a view to ensuring that inefficiencies in the banking institutions are reduced to the minimum,
the banking system maintains integrity and financial soundness, and the
observations/irregularities pointed out by the SBP are taken seriously by banks and rectified
promptly, it has been decided that, in addition to any other action that SBP may institute
against any functionary of a bank or financial institution under Section 83 of the BCO, 1962,
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the following scale of penalties will be applicable with immediate effect in respect of various
categories of violations of rules and regulations. (Khan, 1999).
Violation of Penalties
A
i) Cash Reserve Requirement.
i-a) Rs 69/- per 100,000/- or part thereof per day on
the amount by which the balance with SBP falls short
of the fixed.
i-b) If the shortfall continues in the subsequent week
or thereafter, the penalty shall be increased to Rs 86/-
per 100,000/- or part thereof per day.
ii) Statutory Liquidity Requirement. ii) Rs 86/- per 100,000/- or part thereof per day on the
amount by which the liquid assets fall short of the
fixed minimum.
B. Instructions regarding operations of
Deposit Accounts and payment of Return.
Rs. 20,000/- per case and /or Rs 100/- per day for the
period of the irregularity, and/or disciplinary action
against responsible official.
C. Instructions regarding operating of
account
Rs 20,000/- per case and/or Rs 1,000/- per day for the
period of the irregularity, and/or disciplinary action
against responsible officials.
D. Security requirement for grant of loans
and advances.
Rs 20,000/- per case and/or Rs 1,000/- per day for the
period of the irregularity, and/or disciplinary action
against responsible official.
E. Instructions / regulations regarding grant
of financing facilities.
Rs 20,000/- per case and/or Rs 1,000/-per day for the
period of the irregularity, and/or disciplinary action
against responsible officials.
F. Rules & regulations including those
relating to issuance off Letter of Credit and
Guarantees.
Rs 20,000/- per case and/or Rs 1,000/-per day for the
period of the irregularity, and/or disciplinary action
against responsible officials.
G. Other Prudential Regulations, provisions
of Banking Companies Ordinance, 1962,
Banks Nationalization Act, 1974 and State
Bank of Pakistan Act, 1956
Rs 20,000/- per case and/or Rs 1,000/-per day for the
period of the irregularity, and/or disciplinary action
against responsible officials.
H. Delayed submission of Returns, Rs 20,000/- per case and/or Rs 1,000/-per day for the
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concealment or misreporting of
data/information to the State Bank of
Pakistan.
period of the irregularity, and/or disciplinary action
against responsible officials.
I. Instructions regarding location, opening
and shifting of branches.
Rs 20,000/- per case and/or Rs 1,000/-per day for the
period of the irregularity, and/or disciplinary action
against responsible officials.
j. Regulations regarding grant off financing
facilities in respect of Export Finance
Scheme/Locally Manufactured Machinery.
As already notified by State Bank of Pakistan from
time to time.
K. Excess lending to autonomous bodies
from their prescribed limit
As notified vide BCD circular letter No. 27/127 Priv-
88 dated 12-11-1988.
3. It has also been decided that, henceforth, banks found to be repeating or committing the
same violations/irregularities in the following year(s)/period(s) except those relating to Cash
Reserve Requirement/Statutory Liquidity Requirement would be subjected to levy of a
surcharge at 25% compounded on succeeding year as compared to the year, it was first
pointed out.
4. Banks are advised to note the new scale of fines/penalties as also their progressive nature
and to circulate among managers of all their branches. It may also be noted that fine/penalty
once levied due to mistake in reporting or any other lapse on the part of banks system as a
whole to ensure compliance with Prudential Regulations other directives of the State Bank of
Pakistan in letter and spirit (Khan, 1999).
1.6.2 Factors affecting Compliance in credit Risk management
Make Money: there is a simple phenomenon about investment that the more risk you
take the more return you get. Sometimes Banks also follow this and give loans to such
individual and Companies who have a bad credit history, credit score, bad position in the
market. But irrespective of all these things they lend them money because of the fact that
by doing so they are earning more interest, and making more money.
Market: when there is shortage of money supply in the market. More and more
companies and individual search ways for generating funds, in these situations banks
usually increase their interest rates, because it’s an opportunity for them to earn good
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profits. Therefore banks do extensive lending in such periods of time which results in
non-compliance of regulations.
1.7 Problem Statement
Are local commercial banks complying with the prudential regulations of State Bank when
giving corporate loans and how are these prudential regulations helping local commercial
banks in managing their credit risks.
1.8 Objectives
To assess and evaluate the internal rating process of bank’s for giving credit to
corporations/ companies and their compliance with Prudential Regulations.
1.9 Justification
The purpose of this study is to analyze the process of commercial banks regarding credit risk
management and whether banks are complying with prudential regulations.
This study will help
Corporations: to understand the criteria of getting credit and what are the regulations
imposed on them by State Bank of Pakistan.
Commercial Banks: those banks who want to initiate their operations in Pakistan.
State Bank: State Bank to know at what extent commercial banks are following credit risk
management regulations.
Students: to understand the credit risk management and how it is practiced in real term by
commercial banks.
1.10 Limitations
Banks might be unwilling to share internal information.
Time and cost.
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1.11 Definition of Key terms
Credit Risk: Credit risk is most simply defined as the potential that a bank borrower
or counterparty will fail to meet its obligations in accordance with agreed terms.
Prudential regulations: The prudential regulation is regulation of deposit-taking
institutions and supervision of the conduct of these institutions and set down
requirements that limit their risk-taking.
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Chapter 2: Research Methodology
2.1 Research Design
This research will be an “Exploratory Research” because the major objectives of research
need a lot of secondary data; moreover research team will also conduct interviews from
related people.
2.2 Procedure
The research team will conduct interviews from related people and also take help from
advisors; team will also go through different literature in order to gain knowledge regarding
the research.
2.3 Population
Population for research consists of all local commercial banks currently operating in
Pakistan.
2.4 Sample and sampling method
The research team will choose three local commercial banks for this study and team will
choose convenience sampling method for the study.
2.5 Measurement/ Instrument selection
Most of the study will be covered through analysis of secondary data and the research team
will conduct the informational interviews from bankers to better understand the credit risk
management and to know how well regulations are being practiced.
24
2.6 Research Schedule
25
Chapter 3: Literature Review
3.1 Introduction to Risk Management
The adverse impact on the profitability of the institution due to some uncertainty is known as
risk (Guidelines for Commercial bank & DFI’S, 2010). Risk management is approach that
seeks to eliminate or minimize the level of risk associated with business operations (Tatum,
2010).Credit risk arises when any potential customer shows unwillingness/ inability in
paying the debt. Credit risk can be further sub-categorized on the basis of reasons of default.
For instance the default could be due to country in which there is exposure or problems in
settlement of a transaction (Guidelines for Commercial bank & DFI’S, 2010).
3.1.1Credit Risk Management framework
The environment of banking is changing all over the world so keeping in view this fact State
Bank of Pakistan also recognized the importance of credit risk management and provide a
guidelines for risk management within financial institutions through. As Razaq (2007) has
mentioned that risk management framework includes four categories i.e. credit, market,
liquidity and operational risks.
3.1.2 Factors comprising credit risk management framework
State Bank of Pakistan suggests the credit risk management framework to financial
institutions that comprises of following factors (Guidelines for Commercial bank & DFI’S,
2010):
Board and Senior Management oversight:
According to Kanwar (2005) The Board and Senior Management is responsible for
formulating a credit policy, develop strategies and transform those strategies for managing
the market risk. Beside that a system is needed to be established to identify measure and
moderate Liquidity risk, and the Board of directors also have to ensure that adequate systems,
procedures are established in order to control all significant areas of operations. (Kanwar,
2005).
According to the State Bank of Pakistan, the bank policy at minimum must cover following
26
factors: (Guidelines for Commercial bank & DFI’S, 2010).
Detailed and formalized credit evaluation/ appraisal process.
Credit approval authority at various hierarchy levels including authority for
approving exceptions.
Risk identification, measurement, monitoring and control
Risk acceptance criteria
Credit origination and credit administration and loan documentation procedures
Roles and responsibilities of units/staff involved in origination and management of
credit.
Organization Structure:
Kanwar (2005) has suggested that the organization structure ideally include a hierarchical
structure which includes an Asset liability committee headed by CEO of the bank, this
committee is responsible for giving updates to Board of directors regarding risk
Management. Furthermore banks should have a mid office between front office and bank
office, this unit is responsible for reporting senior management regarding treasury options.
Moreover bank must make sure that funds are utilized for same purposes for which they were
provided and proper administration (proper documentation, credit disbursement, loan
repayment, proper monitoring and collateral and security documents must) be done while
giving credit facility. Proper measurement of credit risk through different qualitative
techniques of rating framework (business risk, financial risk, internal rating, exposure rated)
must be done. Summing up the banks must monitor the individual financial position, purpose
of credit, risk associated with specified purpose of credit and bank’s portfolio of providing
credit facility while providing credit facility (Guidelines for Commercial bank & DFI’S,
2010).
3.1.3 Component of Credit Risk Management
Credit risk management include following six essential components: (Razaq 2007)
Clearly defined lending policies
Credit portfolio quality review
Credit risk management policies
Policies to limit or reduce credit risk
27
Asset classification
Loan loss provisioning policy
3.2 Role of credit Ratings in Credit Risk management
Credit ratings always play major role in measuring the corporate credit risk quality.
Conventionally there was a thought that credit ratings provide information about likelihood
of default and forms of corporate failure (Hilscher & Wilson, 2010). Credit ratings provide
information to banks about how much amount to be lent to any company (Colley, 2010).
Therefore Banks need to review their portfolios periodically including fund based exposure
to corporate or individual. During these reviews banks can increase the interest rate for high
risk customers or offer high credit limits for customers who have low credit risk rating. By
doing so banks will not only protect their principle but they will earn more profits. For this
purpose those companies who have high credit risk rating are reviewed more frequently
against those companies with lower credit risk rating (Colley, 2010).
3.2.1 Aspects of Credit Rating
According to Colley (2010) credit ratings no doubt add information in collecting data for
company failure but in recent year it contribute a little to marginal default prediction and
variation in default probability over time. So Credit rating always captures two different
aspects of the risk i.e. forecast corporate failure and systematic risk. As suggested by
Hilscher & Wilson (2010) credit ratings are easily improved by available public data and it
also fails to differentiate between two corporate having same rating as default probability do.
In systematic risk measurement credit ratings are as effective as probability of default or
expected payouts. Since credit ratings are not effective in measuring the default risk but it
provides more information to agencies and institutions in finding accuracy in data. Therefore
credit ratings provide healthy information about variation in systematic default risk and that
such variation is important to investors (Hilscher & Wilson, 2010). Systematic default risk is
the tendency to default in bad times, times when share prices are low, unemployment is high
and other bonds are more likely to default. Summing up there is not any harm in measuring
credit risk with more than one measure. It is always good to find out short term default
predictions from the measurement of long-run systematic risk. The former measure could
28
update frequently and rapidly respond to news while the latter could be similar to current
credit ratings (Hilscher & Wilson, 2010).
3.3 Banking Reforms in Pakistan
State Bank of Pakistan always play major role in bringing revolution in the banking industry.
According to Farooq, Afridi and Alam an example of such revolution was experienced in
year 2004. Some of the most important reforms are: (Farooq, Afridi & Alam, 2010).
Strict corporate governance standards were introduced.
More priority was given to Risk Management in the loan portfolio management.
Supervisory and regulatory capacities have been upgraded.
Instead of political influence, commercial consideration was given more preferences.
Recruitment and selections at large level were done on merit basis.
E-banking/ online banking was promoted.
3.3.1 Impacts and Implications of Banking Reforms
These reforms had positive impact on the banking systems and their profitability, some of
them are mentioned below: (Farooq, Afridi & Alam, 2010).
Increase in capital adequacy ratio was seen.
Asset quality has improved curtailing the flow of non-performing loan.
Expert and more professionals were hired at the top and second tier level of
management.
Great increment was seen in earnings of bank
Besides above reforms another major change was made in banking industry in same year
(2004) which was using KIBOR as standard for corporate lending. According to Aazim
(2004) the heads of all banks and senior officials of state bank along with Deputy Governor
conducted a meeting and in which took a decision of using KIBOR as a reference rate for
corporate lending by banks. According to Khawaja & Khan (2008) The main reason behind
29
this plan was to introduce some uniformity in corporate lending rates, and this will also make
corporate more efficient in cash flow management. Many SBP officials consider that use of
KIBOR as a reference rate (for corporate lending) will make the monetary policy more
effective (Aazim, 2004).
3.4 Credit Risk Management Process: How to avoid lending disasters and
maximize earnings
Credit risk management is applied on the presence of risk and uncertainty to control the
earnings from lending to a borrower (Colquitt, 2007). The Process of a typical credit risk
management lifecycle contains four steps namely Collect Obligator and loan Data, Compute
credit risk, Monitor and manage credit risk rating and Portfolio Management/Capital
Allocation. As suggested by Gorge, Sinha and Murali (2008) first the data needed is about
borrower and their profile, then the loan and external data which are the ratings. Then the
data on the maturity, nature of the loan, amount lent, collateral, guarantees and contract terms
and conditions. Secondly, the credit risk involved has to be computed in the form of risk
ratings to differ the risk among different firms or exposures. Third, the monitoring and
management of risk rating takes place in which notifications are ensured on changes in
external ratings. Lastly, the portfolio management/capital allocation is performed in which
the organization must perform back testing of ratings (George, Sinha and Murali,
2008).Credit risk occurs due to the fact that when a lender stands the chance to lose from a
borrower who becomes unable in repaying their debt that which was contracted. Risk Credit-
related losses relate to those business transactions that are contracted for and take place due
to various scenarios (Colquitt, 2007). The most common scenario is a borrower’s failure to
pay interest or the principal amount on a direct or contingent loan contract and also from a
borrower’s declining credit quality that shows lower value on their debt obligation. Credit
risk is present in every in all the borrower’s business activities and is a component in every
commodity that they provide (Colquitt, 2007).
3.5 SBP amendments in Prudential Regulations
As given in SBP amends banking prudential regulations (2009), there was an amendment in
Para 2 of Regulation R-3 of prudential regulations for corporate and commercial banking
30
regarding minimum conditions for taking exposure, and has asked the banks to replace the
above referred Para as under: (SBP amends banking prudential regulations, 2009)
"Banks/DFIs shall, as a matter of rule, obtain a copy of financial statements duly audited by
a practicing Chartered Accountant, relating to the business of every borrower, which is a
limited company where the exposure of a bank/DFI exceeds Rs 10 million, for analysis and
record”. "The banks/DFIs may also accept a copy of financial statement duly
audited/certified by a practicing Cost and Management Accountant in case of a borrower
other than a public company or a private company, which is a subsidiary of a public
company.”However, if the borrower is a public limited company and exposure exceeds Rs
500 million, banks/DFIs should obtain the financial statement duly audited by a firm of
Chartered Accountants which has received satisfactory rating under the Quality Control
Review (QCR) Program of the Institute of Chartered Accountants of Pakistan (SBP amends
banking prudential regulations, 2009).
3.5.1 Exemptions
The above mentioned requirements are waived under these two conditions: (SBP amends
banking prudential regulations, 2009)
1. When the exposure does not exceeds the limit of 10 million.
2. When liquid asset is placed as collateral against exposure. Then the financial
statements signed by a borrower are adequate.
Chapter 4: Analysis
4.1 Lending Procedure
The lending money or providing financing facility to any corporation is not a piece of cake
because if any corporate is seeking business credit, it needs to make sure that there given
31
venture(the reason for which it is seeking finance) is in the best possible financial position.
For this every bank has internal policy regarding the providing credit facility in accordance
with policy of State Bank of Pakistan. It involves the proper structuring of loan, proper
evaluation and monitoring credit risk and interest rate selection and payment.
4.1.1 Allied Bank Limited
According to Mr. Ahmed; ABL focuses on various aspects while providing financing facility
to any corporation. It basically evaluates customer on different parameters i.e.
Annual review of customers (a report that shows the performance of company in the
industry on annual basis).
Current ratio (It tells company’s current assets against their current liabilities).
Financial statement (Balance sheet, income statement, cash flow statement,
statement of equity).
Leverage Ratios (Measure the extent to which non-owner supplied funds have been
used to finance the firm’s assets).
Interest Coverage Ratio (Measures the how easily company can pay interest on its
outstanding debt).
Moreover the given specific areas help the bank in understanding the customer very
thoroughly and also help in decision making process and tell feasibility of providing the
credit facility to customers.
4.1.2 NIB Bank
According to Mr. Bilal when NIB Bank goes for corporate lending it does not focuses on
thing; it evaluate customer on different aspects i.e. there past five year trends in the
industry, how much profit/ loss it make in these years, the financial statement, company’s
strength and different ratios. After evaluating them properly we determine that is
providing financing facility to respective company should be worthy or not.
4.1.3 United Bank Limited
According to Mr. Mustafa; providing credit facility to any corporation is not a new thing for
them but currently they also look the opportunity of growth in the business, impact of
external factors i.e. law and order situations (no one knows what happens in near future and
32
when holidays will be announced, these type of actions may effects the performance of the
corporation so risk is also involved with external factors), its stability in the market,
following the policies of State Bank, evaluating different ratios, company’s financial
statement (cash flow statement, Balance sheet, Income statement), company’s strength and
other related factors.
4.1.4 Focus areas
According to all three Bankers (interviewers) all the areas discussed in the above question are
very much important because these areas help them in understanding customers in greater
perspective i.e. customer’s ability, its performance in industry, its total debts and total assets
and how frequently they pay their debts and interest. In short we can say that it help in
decision making showing feasibility of providing finance facility.
4.1.5 Customer Analysis Package
Customer analysis package include all above reports but in addition to this banks also
analyze the production capacity means how much an asset produce in one go, how much
amount is used in machinery, either the assets are utilized fully or they are underutilized;
reasons for being underutilized. Moreover key suppliers are also get focused because if in
case supplier delays in providing raw material then it will effect there production cycle
means difficulty in generating revenues means a situation of default may be arise. In this
package key customers also get focused because these are main players by which a company
exists in the market.
4.1.6 Compliance with Lending Process given by State Bank of Pakistan
According to the Mr. Ahmed, Mr. Bilal and Mr. Asif Mustafa every bank have to follow the
rules and regulations given State Bank of Pakistan because it is the regulatory body of all the
banks working in the industry and moreover it is the body that regulates the monetary policy
of the country. Breaching the given set of rules means Prudential Regulations will not only
problem for the banks but State Bank can also penalize them on their PRs breach. The given
PRs are very much helpful because they keep them in limits and stop them in investing their
money in risky ventures. Moreover State Bank asks banks to strictly follow the regulations
that will help them in securing the money of common people. In short Banks have to follow
the Prudential Regulations otherwise they will b penalize by State Bank of Pakistan.
33
4.2 Issues in implementing prudential regulations
In our interviews with all three banks , Research team identified that bank faces some
problems in implementing prudential regulations, specifically when state Bank bring any
change in prudential regulations, because in this case the bank has to review its internal
policy, and diminish the loopholes in the internal policy in accordance with SBP
amendments. Otherwise there are no such issues in implementing PR.
4.2.1 Satisfaction & Challenges
It seems that banks are satisfied with the prudential regulations; satisfaction is that the
regulatory body that is watching over the process has standardized everything. This means
that almost every bank has to work on the same pattern and follow the same guidelines. But
the dissatisfaction can be that banks have to take decisions within predetermined limits or
else they would be penalized by SBP. The challenge is that the banks have to work within a
regulatory framework and have to protect the interest of depositors and ensure the provision
of capital to customers.
4.2.2 Advantages of implanting Prudential Regulations
The Advantages of prudential regulations are:
1. It helps in managing the risk
2. It standardizes the bank policies
3. It gives a framework for lending
4.2.3 Disadvantages of implementing Prudential Regulations
The disadvantage is that there is no flexibility, as Syed Ahmed said that sometimes we have
to refuse our very good clients, because of the limit on funded based exposure, and such
decisions have a negative impact on our relationship with good clients.
4.3 Exemptions
ABL’s lending policy to corporate is not very rigid and it varies from situation to situation
and customer to customer. As nowadays as economy is not performing well therefore
investment in economy has dropped. So ABL do give exemptions to preferred customers as
they contribute to higher profits and to retain them and make them loyal with the bank,
34
special exemptions have been given to these customers. As Syed Ahmed of ABL said that
they provide different exemptions, such as more lending to a single customer by SBP, the
grace period in repaying of debt etc. Also NIB’s Bilal elaborate the point that banks have to
give special treatment to its preferred customers and they cannot be treated in the same way
as they treat ordinary customers corporations like Unilever, ENGRO etc have to treated at
different level because they are big players in the market and their transactions are in
millions which are the main contributors in the profitability of bank. UBL’s policy is little bit
different from its rivals as Mr. Asif Mustafa told that good relations are made only with those
corporate which are profitable for the bank so god relations mean good profits. Corporate
which are profitable for bank, off course, long term relations are formed with them and gave
exemptions to them where required. However, before giving these exemptions to any
customer they must first take permission from SBP and if SBP permits then these exemptions
are given to preferred customers. Also these exemptions are not provided or facilitated to
every customer and banks and customers should have good prior relationships in order to
become eligible to these exemptions.
4.4 Evaluating Credibility of Customers
According to Allied Bank, the specific reports that they follow are CIB reports, annual
reports of the company such as the financial statements, auditor reports and how auditors
evaluate the spending of the company in the industry. UBL looks at the CIB and information
from other banks and at NIB, the biggest and most credible source right now is the market
itself. They look at how the company perceived in the market through word of mouth. You
can find out how the company is doing from there and then you get to know their credibility.
Also if you wish to finance them then you should look at the CIB reports, the information
provided from the State Bank of Pakistan, auditor reports and financial statements to find out
the credibility of the company. The Credit information Bureau (CIB) is a key element in
knowing the credit worthiness of a borrower.
4.5 Shares as Collateral
Research Team identified that banks do take shares as collateral while providing financing
facility, but before that they evaluate the shares in terms of present value, volumes etc, but
35
most importantly the company that is giving shares to the bank as collateral for borrowing
money, it should be listed in the stock exchange.
4.5.1 Credit rating and risk involved in shares
The banks that we interviewed give financing against A+ shares, but in case if the company
needs more financing or if the banks think that they will be getting more profits by entering
the deal with that company then they can accept B+ shares as a collateral but in accordance
to section 23 of the banking ordinance 1962, which says
“No banking companies shall hold shares in any company whether as a pledge, mortgagee or
absolute owner, of an amount exceeding 30 percent of the share capital of that company or
thirty percent of the paid-up share capital and reserves, whichever is less”
So this ordinance really helps in keeping banking investment secure, because banks have a
limit on taking shares as collateral. Due to which the risk involved becomes systematic and
hence diversified, so doesn’t matter share is of A+ rating or B+ rating, banks have control on
the risk, which is very necessary especially when you are an investor in Karachi stock
exchange, because it’s very volatile, you never know when the market will go up or when it
will crash down.
4.6 Unsecured Financing
ABL’s policy in this regard is very clear as they do not provide unsecured lending and the
reason is that it will increase the credit risk, also its against the prudential regulations in
which it is clearly stated that no bank can do unsecured lending, borrower have to pledge
anything which is acceptable as a security in order to finance its loan. So ABL strictly follow
the law stated by SBP. NIB’s Bilal also mentioned that it is not the bank’s policy to provide
unsecured financing and also the regulatory body i.e. SBP do not permit to do so, so in order
to make transaction safe and secure borrower have to provide security, if borrower becomes
default then that security should be sell in order to recover the money. Like other banks UBL
also did not take the risk of unsecured financing because it is risky and also against the
prudential regulations stated by SBP as Mr. Asif told.
36
4.6.1 Key Finding of Unsecured Financing & Exemptions
All the banks are looking for good relations with corporate which are profitable for them, not
only good relations are established with them but also special exemptions are given to them
like competitive interest rates on principle amount, grace periods etc. These exemptions help
in building long term relations with the corporate. Banks do not give any exemption to any
corporate without taking permission from SBP because every bank have to follow PRs as a
law stated by SBP, so if any bank want to go beyond these laws first bank have to take
permission and if SBP permits only then these exemptions are given otherwise any bank who
violated these regulations will be penalized by SBP.
Other thing is that due to economic downfall in country no bank is ready to take risk of
providing unsecured lending. So UBL, NIB and ABL do not go for unsecured lending, its
bank policies now that they would not provide unsecured lending.
4.7 Optimum Current Ratio
According to the Prudential Regulations the current ratio of any borrower should 1:1 means
that measuring the liquidity of company by calculating its assets and liabilities. Moreover it
indicates the ability of company to pay short term obligations. According to all Bankers their
respective banks follow the prudential regulation means give loan to those clients who have
optimum current ratio of 1:1 or more than 1. But in adverse situation means when company
do not have current ratio of 1:1 but it wants financing facility then banks after evaluating all
other factors and permission from State Bank and if they get positive signal then they go
beyond and provide financing facility and ratio is up to 0.75.
4.8 Monitoring Process
ABL evaluates the company by looking at how the companies stocks, annual reports, the
insurance of stocks and their receivables are performing. UBL does the same as well as look
at the production capacity of the company that is borrowing. The stocks help to evaluate the
company’s position in terms increase and decrease in earnings. NIB’s monitoring process is
that they look at the stock market and its fluctuations, the key suppliers and buyers, its
expansion (if any), different reports and also SBPs Ratings. If a company has an increase and
decrease in stock prices, then there is an indication of an increase and decrease in the
37
company’s earnings respectively. Due to the risk on stocks, they should be backed by
insurance and therefore a check on insurance of stocks is necessary incase the stocks fail to
pay dividends. Receivables are important to know how much others owe the company which
gives an idea of the amount of cash that they won’t have temporarily or permanently due to
chances of non-payments. The key buyers and suppliers are to be well known by the bank as
they are crucial to the company’s business and if something happens to them, then the
company could be at risk of losing some business. Expansions indicate that how much the
company is pushing its finances to make an expansion and the amount of cash and leveraging
it will require.
4.9 Penalties imposed by State Bank in year 2008 and 2009
BankYear
2008
Year
2009
NIB 59,674,000 1,335,000
Allied Bank Limited 215,641,000 32,095,000
United Bank Limited 258,321,000 64,552,000
The above table shows that penalties imposed by State Bank on NIB, ABL &
UBL are very high, so this shows that these banks are violating some prudential
regulations of SBP, due to which they are bearing high penalties.
Chapter 5: Conclusion & Recommendation
5.1 Conclusion
Risk is a variable that always been present for banks when giving loans to corporate
clients. Managing this risk is a tedious task that requires a lending process for banks to
follow to keep a check and balance on the loan and the client themselves. However, these
internal lending procedures are not enough to lower the overall risk in corporate lending
and therefore the State Bank of Pakistan has produced a set of Prudential Regulations to
38
keep banks from over lending and indulging in unsecure loans. In the research of credit
risk compliance in corporate finance we found that banks have a lending process that is
similar to one another and these procedures are followed in accordance with the
Prudential Regulations. Any bank operating in Pakistan has to follow these regulations
otherwise it will be penalized by SBP. Banks also have comprehensive internal rating
process through which banks evaluate different customers before financing them. Overall
banks comply with prudential regulations and most of the banks are satisfied with PRs as
these regulations provide guideline for banks while lending money and PRs also make
sure that there will be standardization in policies among each bank while financing any
customer.
5.2 Recommendations
State bank Prudential regulations are for the benefit of local commercial banks.
Therefore Banks should adequately follow them, in order to ensure compliance and
avoid any kind of liquidity problem.
Amendments in prudential regulations shall be made by State Bank, keeping in view
the economy of the country. For e.g. During expansionary policy, the limit on fund
based exposures shall increase, and during Contractionary policy, the limit on fund
Based exposure shall be decreased.
State bank should also take suggestions from all the banks operating in Pakistan,
before introducing and implementing any new policy.
5.3 Areas of further research
Further Research can be conducted on multinational and Islamic banks currently
operating in Pakistan.
What are the prudential regulations of State Bank of India and other Asian
countries, and what are the internal policies of Banks operating in those country.
39
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Appendix
Questionnaire
Objective: The objective of this questionnaire is to identify the lending procedure of
different banks to corporate in accordance with Prudential Regulations and procedure of
lending as given by State Bank of Pakistan.
Interview questions
Q1. What is the procedure of lending to companies followed by your bank?
a) What are the specific areas that you focus while providing credit facility to any
corporate?
43
b) Which area do you give most importance and why?
c) Is there any specific lending process given by State Bank of Pakistan to follow; if yes
then briefly discuss.
Q2. What issues do you face when implementing prudential regulations?
a) Are you satisfy with the policy and regulations stated by SBP?
b) What challenges do you face while practicing these PRs?
c) What are advantages and disadvantages of PRs?
Q3. To what extent does the good relationship between the bank and the company have
impact on the lending procedure?
a) What exemptions do you give to your preferred customers?
b) Why do you give these exemptions to your preferred customers?
c) What is the evaluation process for preferred customers?
Q4. Name some specific reports that help in evaluating the credibility of customers?
a) What are these reports and why do you choose these specific reports?
b) Has SBP ordered to follow these reports while evaluating the credibility of
customers?
c) Are there any challenges you face while collecting information and evaluating these
reports?
Q5. As stated in your annual report what exactly is the total lending break up?
a) Corporate______________________
b) Groups________________________
c) Individuals_____________________
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Q6. Does your bank take shares as collateral on providing financing facilities?
a) Does your bank prefer risky shares as collateral for higher profitability?
b) What credit rating is acceptable on shares to take as collateral?
Q7. Does your Bank provide unsecured financing? If yes then
(a) What is your limit on exposure against unsecured financing facilities?
(b) What are the reasons for giving unsecured financing?
(c) To whom does your bank give unsecured financing facilities and why?
Q8. According to your bank, what should be the optimum current ratio of the borrower
(Company/entity) for credit financing and why?
Q9. What is monitoring process after giving loan to any entity/group?
a) How often does your bank evaluate the entity/group after giving financing facility?
Allied Bank Limited
Interview from Saeed Ahmed, Vice President and Team Leader of Corporate and Investment
Banking.
Assalam-o-Alaikum, guys I am Saeed Ahmed, are you guys are from Szabist, yes we are
from Szabist and we are studying in 7th Semester and actually we are here for a meeting
regarding thesis, ok, what is the topic of your thesis, Sir the topic is credit risk compliance in
corporate finance, basically in this research we are trying to identify that whether local
banks are following prudential regulations. Right, so what would you want to know? Sir we
have a questionnaire and we will be asking the questions accordingly. So you just have to
answer those questions. Ok go ahead.
Q: What is the lending procedure to corporate followed by your bank?
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Ans: Well, our lending procedures contain various aspects. One would be the annual review
of customers in which the customer is reviewed on the basis of current ratio; financial
statements are the basic essence of our lending procedures review. Other than that we look at
leverage ratios, interest coverage ratio and company‘s strength. This is the very common
format in the banking industry for lending. Sir you just mentioned specific aspects like
current ratio, liquidity ratio, but can you please elaborate that what is annual review of
customers. Basically annual review report is a yearly report that shows the performance of
company in the industry, and the way it operates. With the help of this we find that is the
company viable for lending, and if it is than the company is eligible for getting financing
facility.
Q: Sir from the areas that you just highlighted, what are the major areas from given above
areas/ which of these aspects are most important?
Ans: Well most of them are major areas, I would say all of these are important areas and they
help in understanding the lending procedure, and if you know these factors well, it will help
you in understanding the customer in a greater perspective, and how to lend them a loan.
Q: Can you please explain customer analysis package that your bank follows? (Please
explain the major internal analysis process)
Ans: The customer analysis package is very general , in which we look at how customer is
doing in its production means production capacity, how much the produce in one go, how
much capital they utilize in machinery; utilization is very important factor and other reasons
for under utilization. For e.g. why they are under utilizing or they working up to the level
required, is management pushing them to utilize all the resources to go for the optimum
level. And other major areas that we look in the customer analysis package are the key
suppliers of the customer and the key buyers of the customers: key suppliers are the raw
material provider, basically who is providing the raw material for the product to be produced.
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Q: Sir, as you said that key suppliers also play major role for granting the loan to the
corporate. For e.g. in case of providing financing facility to Engro why do you need to look
at its key suppliers?
Ans: Basically the key suppliers facilitate the production and in case if any suppliers fails to
supply raw material, then Engro certainly will back out and will not be able to produce and
hence there would be no profit and they will not be able to payback. Therefore in this case
lending facility wouldn’t be provided.
Q: Sir any specific lending procedure given by state bank that you follow?
Ans: Yes, State Bank policies are followed in any case; the set of prudential regulations
given by state bank. Those are the basic rules and regulations that we have to follow for
giving loan to any company. It facilitates us in giving exposure to the company.
Q: Do you follow the set of prudential regulations as given by state banks or you depict your
policy from it?
Ans: We have to follow the regulations of state bank in any case, and we can’t breach them.
And if we don’t follow them we would be penalized and every bank has to follow them and if
you analyze report you will find trends in them.
Q: Are you satisfied with polices/ prudential regulations given by the state bank?
Ans: it’s not about being satisfied, we have to follow them in any case. Then as I earlier told
that if we don’t follow them we would be penalized.
Q: What are the specific challenges that you face while practicing PRs?
Ans: Challenges are that if there is any change in any Prudential regulation, for e.g. if state
bank changes the limit on company exposure from 35% to 45%. Then we have to review the
entire process that how much exposure can be given and how much lending is allowed.
Q: What are the advantages of prudential regulations?
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Ans: Well the advantages of PR are not much as it cannot be personalized or changed, we
stay in the limits of PR, and it provides a standardized guideline that we have to follow. And
it also supports in risk management
Q: what are the disadvantages of PR?
Ans: the disadvantage is that it’s not flexible. For e.g. if Engro is a very good client of ours
and wants an exposure of 50%, then we are bound by prudential regulations that exposure
can’t exceed 30%. So that is a disadvantage of PR.
Q: Are there any exemptions given by your banks to preferred customers?
Ans: Yes, we do give considerations to preferred customers after getting permission from
SBP.
Q: how do you take permission from SBP and about what?
Ans: It depends on the business opportunity we are getting by giving loan to the client. We
have to inform SBP about the scenario then get permission from then, and if it is approved,
then we go for lending.
Q: Why do you give these exemptions to preferred customers?
Ans: We give them exemptions because of the fact that they give us high profit. As you are
aware of the fact that our agricultural sector is devastated by the floods, this shows that
Engro fertilizers have a great sales potential in the future. In this case we will be really
looking forward for providing financing facility to Engro fertilizers, but of course after taking
permission from SBP.
Q: What are the specific reports that you follow in evaluating the customers?
Ans: The specific reports that we follow are CIB reports, Credit reports of Company, annual
reports of the company (Financial Statement), and then we have the auditor reports; and how
auditors evaluate the spending of the company in the industry.
Q: Which auditing firm conducts the audit of your bank?
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Ans: We choose our auditor from the big five firms.
Q: Does SBP ordered to follow these specific reports which you mentioned earlier?
Ans: No actually they aren’t any. It’s part of the internal policy.
Q: Does your bank take shares as collateral in providing financing facility?
Ans: Yes, we do finance against shares, basically we take shares as collateral, but before that
we evaluate them and find their value and then provide financing facility.
Q: Does your bank give financing facility against risky shares?
Ans: No, we give financing facility against those shares which have a minimum rating of B+.
And mostly we take those shares which have A+ rating.
Q: Does your bank provide unsecured financing?
Ans: No!
Q: What is the optimum current ratio of the borrower that your bank follows?
Ans: The optimum current ratio should be more than one.
Q: What is the monitoring process after giving financing facility?
A: We keep evaluating the company; how their stocks are going we also look at their annual
reports, and the insurance of stocks and their receivables.
NIB Bank
Bilal Khan, Team Leader of Corporate and Investment Banking.
Assalam-o-Alaikum I am Bilal, sorry I am a bit late coming here. So how can I help you? Sir
Basically we are doing a thesis in which our topic is credit risk management compliance in
corporate finance, a case study on local commercial banks in Pakistan. We need to ask
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questions related to your bank. So basically you are doing this topic on whatever is related to
corporate lending, I understand.
Q What is the lending procedure that your bank follows?
A: It is like when you go onto corporate lending, you do not focus on one thing. First you
have to look at the trend in the past five years that how much profit and loss they are
showing in their statements. Also what the company’s strengths are and who are they
supplying their products too. So over these aspects our bank decides the lending procedure.
Q: Do you measure a specific area before giving a loan to the company?
A: In such specific areas we look at the current ratio, leverage ratios, and then the liquidity
ratios. If you go into more detail then we will look at the long term borrowing of the
company. You have to look at depth in such certain areas that our team assesses that how the
company is performing.
Q: Is there any specific lending process given by State Bank that you follow?
A: Yes there is a lending process and we follow it strictly and if you have gone through the
Prudential Regulations available on their website hopefully you have viewed them. There
they have clearly defined how to carry out the lending procedures.
Q: Are you satisfied with the Prudential Regulations that the State Bank has provided?
A: It varies and mostly it depends on the situation at hand. The satisfaction is that there is a
regulatory body that is watching over the process that has standardized everything. It’s not
like that some bank has made its own policies or our bank has its own set of policies to
follow. If such a situation was the case then this would have created a mess. The satisfaction
is that there is a standardized process that everyone in the industry will follow.
Q: Are there are some challenges when practicing the Prudential Regulations?
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A: Look it depends on the situation again, like when you actually face the challenges. For
example like when you have to give someone a loan outside your own premises and if you
wish to go outside your premises and the authority is stopping you, so then this a challenge
for you because this can affect your relationship in the long run. So this is the main challenge
however if you look at it in general then there is no major issue.
Q: Can you tell us some advantages of Prudential Regulations?
A: Like I just told you a moment ago about the Prudential Regulations that there is a
standardized pattern. Like in the Prudential Regulations its policies say that you cannot do
anything other than what has been specified so there is no question of changing the
regulations according to your requirement. So it is a straight forward pattern that everyone
has to follow.
Q: Can you tell us some disadvantages o Prudential Regulations?
A: As such there are no disadvantages of Prudential Regulations because there are
advantages and guidelines that help you in risk management.
Q: Do you have exemptions for your preferred customers?
A: Yes of course we do, if you look at any bank they do. Take any bank and they will have
specific clients who they deal with on a preferred basis. For instance if I take the example of
a multinational like Unilever, everyone wants to do business with Unilever because their
transactions are in millions and they are very profitable for any bank. So you will not treat
them like an ordinary customer, you have to give them preference to show that you care for
your preferred customer. So yes we do give exemptions and sometimes extra exemptions
which we take approval for from the State Bank of Pakistan. If the State Bank Permits then
we give them the extra exemptions.
Q: Are there any specific reports you follow in evaluating the credibility of the customer?
A: The biggest and most credible source right now is the market itself, that how is the
company perceived in the market, such as through word of mouth you can find out how the
company is and then you therefore get to know their credibility. Apart from that if you wish
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to finance them then you look at the CIB reports, the information from the State Bank of
Pakistan, Auditor reports and financial statements to find out the credibility of a company.
Q: Can you give us a break up of your lending?
A: If I tell you about us then we have around 100 to 150 corporate clients. In these clients
you have small, medium and large sized clients. So if you look at our overall lending then we
have given 15% loans to corporate clients.
Q: Does your bank take shares against financing activities?
A: Yes we do and we give financing against shares.
Q: According to a famous metaphor of High risk and High gain, do you also give financing
against risky share?
A: As I told you before that if a company is not listed on the stock exchange then we do not
give financing against it. Look it depends on the relationship between our bank and the
company if the relationship is good then if even if the share is even a bit risky such as a B+
rating then we still give financing against it. Otherwise we will only give financing against
A+ rating share.
Q: Does your bank give unsecured financing?
A: No we do not as it is not our banks’ policy.
Q: Recently Dewan Group defaulted, also SBP’s policies have changed so do you think it is
because of Dewan?
A: Yes you are right as you know that Dewan is a well known group and it plays a vital role
in the running of our economy, but you cannot say that it has completely defaulted however it
has delayed payments which has caused certain banks NPLs to increase and cause overall
lending to decrease. The decrease in lending power of banks has put on a negative impact on
banks and if they recover then there is a chance that things come back on track.
Q: What is the optimum current ratio that you follow for corporate financing?
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A: We look at a current ratio that is one is to one or over one and if it is a good relationship
then we even accept up to a current ratio of 0.75.
Q: What is the monitoring process after giving financing to any company?
A: Our monitoring process is that we look at the stock market and its fluctuations, the key
suppliers and buyers, its expansion, different reports and also SBPs Ratings.
Q: You said that you look at Key buyers so why do you look at them?
A: If I have Unilever and they want Rs.20 million financing, I know they have credibility in
the market, I will look at their product and its forecasting and see if the product will have
demand or not. If the product will not have any demand in the future or that it won’t run then
we will think it over that if we wish to finance them or not.
So anything else?
No sir, thank you.
Thank you
United Bank Limited
Interview from Asif Mustafa, Assistant team Leader of Corporate Banking.
Assalam-o-Alaikum, I am Asif Mustafa, so you guys are here for your thesis work right?
Yes sir we are doing thesis on Credit risk compliance in corporate finance.
Ok so how can I help you?
Sir we have designed a questionnaire and will ask you questions accordingly.
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Basically in this questionnaire we try to identify what is the lending procedure that your bank
follow while providing financing facility to any corporate. So my first question is:
Q: What is the lending procedure that your bank follow while providing financing facility to
anycorporate?
A: As you are aware of the fact that the industrial sector in Pakistan is not doing well doing
to some technical crisis and law order situation etc. and therefore keeping the scenario and
the State Bank practices in mind we have designed our internal policies in which we consider
these factors while lending to the corporate. So these factors can be like leverage ratio,
current ratio, the company's worth, financial statements and many more.
Q: Sir what are the specific areas that you give most importance while providing credit
facility?
A: Uh, as I told you before we evaluate different ratios, but if we talk about specific area we
particularly go through balance sheet, cash flow, etc.
Q: Sir is there any specific process given by state bank to follow?
A: Yes we and all the other banks follow the prudential regulations stated by State Bank of
Pakistan
Q: Sir what issues do you face when implementing the prudential regulations?
A: No such issues in implementing PR because they are here for guiding bank and regulates
corporate lending.
Q: Sir are you satisfied with the Prudential Regulations given by State Bank?
A: If you ask me as the manager I would say not satisfied with the PR.
Q: Why sir?
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A: Because due to them we are bounded and take decisions within predetermined limits but I
would say as a guideline or a blue print they benefit us a lot so they are very useful.
Q: Sir then what are the advantages of PR?
A: There are many advantages like they give us a set of guidelines to run the bank, too run
the system. Then they also give stability in lending, in risk management, so there are many
advantages.
Q: What are the disadvantages of the PR?
A: Uh, you have to work in limits, so if you wish to lend more to any client keeping the
business relations in mind you cannot lend those more because of these limitations and
capping.
Q: To what extent does the good relationship impact on the lending procedure?
Ans: We try and maintain our relations with those companies from whom we get maximum
transactions and high profits; therefore for such corporate clients there are certain
exemptions.
Q: what are those exemptions?
Ans: These exemptions are: we charge them competitive interest rate on the principle and we
also give them grace period.
Q: what is the evaluation process for these preferred customers?
Ans: The evaluation process is almost same but off course we know more of our customers
therefore we just follow basic steps of lending procedure.
Q: Give us some reports that you use while evaluating the customers?
Ans: I can’t give these reports but I can tell you about them, these are:
Credit Information Bureau
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Credit Rating Reports
Reports from other banks (In case if that customer/corporation has taken exposure from that
bank).
Q: Has State Bank ordered to follow these reports while evaluating the customers?
Ans: No SBP does not ordered to follow all these reports except auditors reports and that too
should be audited by one of the big five auditing firm.
Q: Does your bank take shares as collateral while providing financing facility?
Ans: It depends on the shares credit rating and if the ratings are positive then we give loans
against those shares.
Q: Does your bank prefer risky shares as collateral?
Ans: Well we prefer A+ rating but if a large financing is required, then we give financing to
minimum B+ rating shares.
Q: Does your bank provide unsecured financing?
Ans: No, our bank does not give unsecured financing because it would too risky and it is
against SBP’s PRS.
Q: What should be the optimum current ratio that you look while providing financing
facility?
Ans: We prefer one is to one (1:1) current ratio.
Q What is monitoring process after giving loan to any entity?
Ans: After giving loan to any customer we regularly monitor their stock prices, company
operations, cash flows, whether receivables are being collected or written off, their
production capacity, potential customers, and key suppliers.
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Q why do you evaluate their key suppliers of raw material?
Ans: It is because we want to assure that in the time of crisis do they have enough material to
product so that their production cycle does not stop.
Q: Why do you evaluate their key customers?
Evaluation of key customers is because we try to find out that do target market have enough
potential that purchase product and can company generate enough revenues so that they can
give money back.
Any other question.
Thank you sir.
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