IN September 2008, the State Bank of Pakistan (SBP) issued an ambitious road map for bolstering the capital adequacy of commercial banks, which required banks to raise their equities (net of losses) to Rs23 billion by end of 2013.

In the case of several smaller banks, it amounted to increasing the equity six-times in as many years.

After the current recession became a reality in mid-2007, coming in late 2008 the road map seemed unrealistic given the expected slow down in the pace of asset growth in banks and the expected decline in bank earnings in the months and years to come. The crash of the capital market that year (the third since 2003) and the damage it caused to investor confidence made it more unlikely for banks to successfully float fresh capital.

The new road map announced by the SBP on April 15 requires banks to raise their equities by Rs1 billion a year until 2013, to end up with minimum equities of Rs10 billion, effectively cutting the earlier target by Rs13 billion or 56 per cent. Given the onset of the recession, lowering the target doesn’t come as a surprise though the SBP has lowered the bar more than expectations – something it must think over once again.

But, in the context of the immediate future, the relief is needed; it will release the pressure for raising profitability in a recession to jack up bank equities, and afford banks more flexibility for realistic rescheduling and re-structuring of troubled loans in their asset portfolios. Let us hope that banks share the benefit of this relief with their distressed borrowers to tide over the challenges posed by recession.

Not only will the relief facilitate banks in keeping the wheels of the industry moving but hopefully, will give banks room for expending more resources on improving their risk selection and monitoring systems to remove distortions therein that induced them into risky lending to compete in the race for enlarging their size so as to move out of the dangerous category of ‘unsustainable’ banks fit for acquisition and mergers.

The earlier capital adequacy road map impliedly pushed the smaller banks into this category by subscribing to the American view that big was both beautiful and sustainable – a view proved wrong by events beginning mid-2007. For the smaller banks, implementing the stiff regulations on capital adequacy and loan loss provisioning were a tough challenge because it was hard to measure up on both yardsticks.

That’s why, bank owners began looking at mergers as the route to survival. Undoubtedly some banks may still have to merge, but the better managed smaller banks have a chance to prove their worth. But the fact remains that capital must rise in proportion to banks’ asset bases to manifest commensurate increase in the stake of bank owners, though it is not a substitute for improved bank regulation and governance in banks.

While lowering the capital adequacy requirements (CAR), is indeed welcome (because alongside relief it insists on CAR being maintained at 10 per cent of the risk-weighted amount of banks’ risk assets), the SBP must remain conscious of the fact that not everything is fine with the banks in the context of risk management and there is dire need of plugging the gaps therein. An indication thereof is the rise in loan delinquencies.

Many losses owe themselves to ‘universal’ banking (going for non-traditional lines such as consumer, housing and project finance, and investing in stocks) by banks ill-equipped for it. Lowering the CAR alone won’t help; banks must be encouraged to become niche-based i.e. setup in-house niche-based research units (not yet institutionalised) and book risks that they can manage with a reliable view of the future risk trend.

This won’t be possible unless: a) there is a focused review of banks’ existing risk management capacities based on a critical examination of the causes of their losses, b) devising a quickly implementable bank-specific remedial strategy, and c) swift implementation of this strategy on a verifiable basis. Should that not happen, lowering CAR may turn out to be unrealistically overoptimistic.

To begin with, it must not be overlooked that banks are handicapped in hedging the variety of risks they carry because we didn’t develop the market in risk hedging instruments, and insurance sector is yet to provide the full range of risk covers that banks need, forcing banks to carry otherwise insurable risks. Secondly, the country risk perception is likely to remain negative until we resolve our security issues.

To compound our problems the external debt keeps rising and internal politics appears unstable. In this backdrop, banks must appear adequately equipped in terms of their commitment servicing and loss-bearing capacities. This perception is crucial for lowering risk premiums, which add to the cost structures of businesses and limit their reach in the overly competitive foreign markets.

Banks’ failure to capitalise larger chunks of the profits they earned during 2002-07 wasn’t a good example of responsibility. The tendency reflected bank owners’ (in fact, their boards of directors’) lack of concern for the future of their organisations. The SBP must insist that banks capitalise a specific portion of their post-tax profit to up the owners’ stakes instead of saddling the depositors with additional risk.

The other worry arises out of the raging controversy over how many regulators Pakistan needs to oversee its financial sector. Given this controversy, to begin with, focus on the review exercise (hinted at earlier) could be diluted; re-assignment of this function to new individuals as the SBP assumes its (likely?) new role as the sole regulator could dilute it even more. Both uncertainties could shift focus away from strengthening regulation.

In addition to stronger and more intrusive bank regulation (need for which has been accepted by the G20 as well), risk cannot be contained unless banks’ support services (that directly impact risk), are regulated without delay because rising loan losses also reflect poorly or wholly unregulated risk-rating, asset valuation, safety and security, and goods clearing, forwarding, transportation and custodial services.

In most countries, all support services except risk-rating are regulated to ensure that these service providers act responsibly and be ready for punishment if they fail. Even risk-rating agencies won’t remain un-regulated; on April 15, the EU passed a law whereby a panel of experts will draft regulations for these agencies, and those regulations will become effective in 2010. Let us hope that we too will follow suit.