AS the deadline for implementing Basel Accord-II comes closer, regulators have been sounding wake-up call to the bankers. In October, they sounded two critically important ones. The first (a softer version of which sounded last year) now lays down a definite timeframe for raising the paid-up-capital and the second, a harsher one, reduces by 50 per cent the time period for loan loss absorption.
Implementing both these measures has become critically important for the banking sector which, during the past three years, has shown a record rate of growth in bank credit. Given the pace of growth in banks’ risk assets, increasing bank owners’ stake in the business needed hastening-up. SBP has very rightly done just that.
High rate of growth in banks’ risk assets had been worrying the regulators for three reasons. First, based on their audited accounts, compared to risk assets the overall capital adequacy of the banking sector had consistently been falling since 2002 from its high of 12.5 per cent. Given the rapid pace of credit expansion, it was likely to fall further unless bank equities were raised without further loss of time. That, unfortunately, wasn’t happening.
Secondly, the pace of growth in risk assets was giving rise to a suspicion that bankers were concentrating more on their growth than on their quality. The view was shared by many observers because of the huge rise in banks’ portfolio of consumer credit. How well-founded is this fear, is yet unknown but the wake-up call reminds the bankers that they must not compromise on the quality of the borrowers they choose to serve.
The wake up call to remedy this suspected weakness takes the form of reduction in the period for gradually absorbing loan losses from two years to one year. It should leave no bank in doubt about the importance of quality of its risk assets.
What makes the regulation’s tone unusually harsh is the fact that it applies with immediate effect to outstanding delinquent bank credit, and will therefore impact bank profitability in 2005. Interestingly enough, after this announcement, bank shares rose sharply on the Karachi Stock Exchange.
Thirdly, inadequate commitment for capitalizing larger chunks of the unusually high profits, that most banks declared during 02-05, prompted SBP to remind banks about their obligations with regard to upping their stake in business instead of passing the bulk of financing risk on to their depositors. The fact that issuing such a reminder became necessary doesn’t reflect too well on bank owners’ sense of caution and corporate responsibility.
The regulation on capital adequacy requires banks to increase their paid-up-capital by Rs1 billion every year until it reaches a minimum of Rs6 billion by December 2009, or earlier. At the same time, banks have to absorb loan losses twice as fast, which will drastically reduce their yearly profit available for capitalization. Together, these regulations will act as a double-edged sword which will test banks’ ability to fight back and survive.
Even though capital adequacy ratio has been falling due to a rapid rise in banks’ risk assets portfolio and their lukewarm attitude to raising bank equities accordingly, the ratio is still above eight per cent— the bare minimum required by Basel Accord-II. It may be argued by number crunchers that SBP is being overly protective by insisting that banks maintain capital adequacy at an unnecessarily high level.
This view, however, isn’t as realistic as it sounds. Firstly, it must be appreciated that banks in Pakistan are handicapped in many ways in hedging the variety of risks they carry because we still don’t deal in many financial risk hedging instruments. Besides, our insurance companies don’t offer the variety of risk covers than banks need. It makes banking riskier in developing countries like Pakistan, and therefore calls for higher loss-bearing capacity among banks represented by higher capital adequacy ratios.
Secondly, in spite of improvement in the past three years, country risk perception about Pakistan remains high. What makes it more unfavourable is the fact that it remains unstable for a variety of reasons including its high external debt and internal political instability. It is prone to going up very quickly. In such a scenario, banks must appear more than adequately protected in terms of their loss-bearing capacity.
In international banking circles, an overly secure perception about Pakistani banks is crucially important if these banks are to deal with foreign banks on a fair basis. If that is not the case, they will end up paying higher risk premiums, which will eventually add to the cost structures of Pakistan’s importers and exporters – a possibility that must be avoided if we are to expand our reach in the overly competitive foreign markets.
For some, especially the smaller banks, implementing the stiff regulations on capital adequacy and loan loss provisioning will be a tough challenge because they will find it hard to measure up on both these yardsticks. Bank owners will have to seriously consider merging together as the easier route to survival. SBP had indirectly been hinting at the need for mergers. New regulations leave smaller banks with fewer choices.
The tougher option is that they improve their performance radically to restrict loan losses to the minimum, ensure high net profitability and thus build a market image that encourages investors to subscribe to their shares in futures issues.
Given the risk management scenario discussed above, it would be tough, though not impossible provided banks can attract high calibre managers and improve their internal control systems. All this adds up to a tall order.
Large banks won’t have an easy time either. Their problems will be proportionately as large. But the fact that they are large, gives them a vital leverage – they will be helped to get out of tight spots because central banks don’t like systemic risk to reach unmanageable proportions as a consequence of big banks getting into trouble. Central banks are not as charitable towards the smaller banks because it is too cumbersome to act as such.
For the smaller banks, there is a message in this explanation; it is far less straining to be a large bank. Whatever intellectuals might say, more than ever before the view that ‘big is beautiful’ applies to the market place. This is the essence of SBP’s wake-up calls.