Undoubtedly, loan loss provisioning is an area that demands the highest level of prudence because, on the one hand it forewarns banks about the consequences of booking loans without adequate concern for their extinguishment within the time frame envisaged at the time of booking them and, on the other about ensuring that all losses are adequately provided for so that banks’ balance sheets reflect their reality.

On October 20 last year, however, SBP issued a circular limiting banks’ ability to avail the benefit of the forced sale values (FSV) of borrowers’ assets (charged or assigned to their lending banks), while making provision for losses arising from loans that aren’t repaid on time. The move compounds the impact of an earlier limitation imposed towards the end of 2005, whereby banks must absorb loan losses in one year instead of two years – a concession that was permitted until June 2005.

This limitation may have serious consequences. Because it could severely punish banks for risk-taking, it may reduce their inclination to book even those loans that carry a ‘reasonable’ risk – the kind banks are expected to undertake. Besides, it could adversely impact the mindset of the business community about building a base of physical assets (land, building, plant and machinery, etc.) from own sources that almost always forms the collateral to secure working capital finance facilities obtained from banks.

Neither outcome would be good for the economy that is facing uncertainties, more so after December 27. These uncertainties are acting as disincentives for investment, that a high population-growth country can’t afford. Let us not overlook the fact that rising inflation manifests not just excess money supply but, far more than that, supply shortages stemming from low productivity that, besides other factors, is caused by the inadequacy of a large base of efficient and productive assets.

Besides avoiding damage to the sentiment for investment, there are more cogent reasons to reconsider this measure, the most visible of them being that not every asset can be assigned a zero value. Seasoned bankers would vouch for the fact that, a bank can realise value from the disposal of collateralised assets subject to: (a) enforceability of the bank’s legal right over those assets, (b) effective ability of the bank to possess them, and (c) ready market for their disposal, even if offering discounted prices.

Therefore, value of assets that are credibly supported by these attributes must not be ignored while making fair loan loss provisions. The problems banks face in realising the value of collateralised assets through courts (which need to be addressed rather than accepted as a reality) shouldn’t imply that, on the one hand we punish borrowers (by reducing the value of their assets to zero) and, on the other, the shareholders of the bank (by forcing banks to record unrealistically large loan losses).

We are headed for tough times not only because of domestic chaos but also due to gradual but definite slowdown in the US economy that, as always, will trigger a global recession. These developments will place businesses under stress and certainly lead to higher loan losses, not all of them of their own making. In the unfolding environment, compliance with the above-referred SBP circular will magnify the problems banks are going to face, hurt their profitability and limit their ability to raise their capital that the SBP is so worried about.

This is not to suggest in any way, that we lower our guard but regulation must be tempered by realism and rationality so that banks remain liquid and survive the coming stress. A realistic approach would be to allow for counting the forced sale value of certain categories of assets while recognising loan losses. For instance: (a) pledged stock of raw materials, (b) pledged stock of finished goods, (c) real estate pledged under a registered charge, and (d) plant and machinery pledged under a registered charge.

In the case of these assets too the relaxations should be made only if the assets qualify on the following grounds:

a) documentation recording the pledge or registration of the charge in favour of the bank has not only been perfected but also audited and certified as such by a legal auditor – a law firm other than that which prepared the pledge/charge documents,

b) assets pledged or charged to the bank are inspected at least bi-annually by competent inspectors and their reports confirming the effective control of the bank over the assets, satisfactory condition of the assets’ inherent and physical attributes that keep them in sale-able condition, and their market values at the time of each inspection.

Credible assessment of the ability of the lending banks to possess and dispose of their borrowers’ assets requires making legal audit a mandatory requirement, which isn’t the case yet. A legal audit implies re-examination by legal experts (other than banks’ lawyers) to establish the legal validity and enforceability of loan agreements and documents whereby borrowers assign or pledge assets to the lending banks.

Second, establishing the sale-ability and market value of the assets requires introducing a stiffer regime of continued asset inspection and valuation. Unfortunately, asset inspections continue to be carried out by unqualified bank employees or hired agents (whose capability is taken for granted), which is wrong; this aberration must be removed by requiring banks to hire inspectors with requisite qualifications.

The decision to disallow benefit of forced sale value of borrowers’ assets charged or pledged to banks while arriving at the net loss that should be recognized reflects doubts about asset valuers’ skills and, perhaps, their honesty. The solution lies in the accountability of PBA that issues licenses to the asset valuers, and institution of robust procedures for weeding out the black sheep among them; it doesn’t lie in taking the route of reducing asset values to zero.

Banks should also be required to set up market monitoring units manned by qualified analysts to continuously track movement in the prices of assets that they accept as collateral to counter-check the accuracy of valuations done by asset valuers. Without this check, banks can’t assess the calibre and integrity of asset valuers to highlight instances wherein they commit errors of judgment. Out-sourcing services doesn’t imply reduction on banks’ obligations; it merely intended to reduce their work load.

By instituting these measures SBP could achieve its objective of ensuring less risky lending by banks without bringing this key sector and the economy under undue pressure. It would not serve anyone to place banks in a position where they become wary of lending or end up making unrealistic loan losses.