Risk Management in Banks

Prudential Regulations for Banks

Meaning of Prudential?
Sensible and Careful when you make Judgements and Decisions. Avoiding unnecessary risk Prudential Regulations contain comprehensive SBP instructions on all aspects

Nature of Prudential Regulations:

Prudential Regulations are both preventive and protective techniques. Preventive regulations forestall /prevent crises by reducing the risks facing banks such as controlling and monitoring the management of banks capital, solvency and liquidity standards and large exposure limits. Protective techniques provide support to banks once a crisis threatens; lender-of-last-resort facilities are of immediate benefits.

Prudential Regulations
The Prudential Regulations are divided in four categories: Risk Management (R). Corporate Governance (G), KYC and Anti Money Laundering (M). And Operations (0).

Need for Prudential Regulations :

The Basel Accord of 1988, prompted the introduction of Prudential Regulations by State Bank of Pakistan with effect from 1 January. 1992,to counter any adverse impact of a deregulated banking sector in Pakistan.

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key objectives of these regulations are outlined below: a) To protect the safety of public's savings. b) To control the supply of money and credit in order to achieve a nation's broad economic goals (such as high employment and low inflation). c) To ensure equal opportunity and fairness in the public's access to credit and other vital financial services.

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d) To promote public confidence in the financial system, so that savings flow smoothly into productive investment. e) To avoid concentrations of financial power in the hands of a few individual and institutions. f) To provide the government with credit, tax revenues and other services. g) To help those sectors of the economy that have special credit needs (such as housing, small business, and agriculture).

Definitions of important terms:

1. Account Holder means a person who has opened any account with a bank or is a holder of deposit / deposit certificate or any instrument representing deposit / placing of money with a bank or has borrowed money from the bank.

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2. Borrower means a person on whom a bank has taken any exposure during the course of business. 3. Contingent liability means: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non- occurrence of one or more uncertain future events not wholly within the control of the enterprise; or

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(b) a present obligation that arises from past events but is not recognized because: (i) the amount of the obligation cannot be measured with sufficient reliability; includes letters of credit, letters of guarantee, bid bonds / performance bonds, advance payment guarantees and underwriting commitments.

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4. Documents include vouchers, cheques, bills, pay-orders, promissory notes, securities for leases / advances and claims by or against the bank or other papers supporting entries in the books of a bank.

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5. Equity of the borrower includes paid-up capital, general reserves, balance in share premium account, reserve for issue of bonus shares and retained earnings / accumulated losses, revaluation reserves on account of fixed assets and subordinated loans.

 6. Exposure means financing facilities whether fund based and / or non-fund based and include any form of financing facility extended or bills purchased / discounted except ones drawn against the L/Cs of Banks rated at least 'A' by credit rating agency on the approved panel of State Bank of Pakistan and any financing facility extended or bills purchased/discounted on the guarantee of the person or credit facilities extended through corporate cards.

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7. Forced Sale Value (FSV means the value which fully reflects the possibility of price fluctuations and can currently be obtained by selling the mortgaged / pledged assets in a forced / distressed sale conditions.

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8. Government Securities shall include such types of Pak- Rupee obligations of the Federal Government or a Provincial Government or of a Corporation wholly owned or controlled, directly or indirectly, by the Federal Government or a Provincial Government and guaranteed by the Federal Government.

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9. Group means persons, whether natural or juridical, if one of them or his dependent family members or its subsidiary, have control or hold substantial ownership interest over the other. 10. Liquid Assets are the assets which are readily convertible into cash without recourse to a court of law and mean encashment / realizable value of government securities, bank deposits.

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11. Guarantees issued by domestic banks when received as collateral by banks will be treated at par with liquid assets whereas, for guarantees issued by foreign banks, with rating of 'A' and above. 12. Medium and Long Term Facilities mean facilities with maturities of more than one year and Short Term Facilities mean facilities with maturities up to one year

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13. NBFC means Non-Banking Finance Company and includes a Modaraba, Leasing Company, Housing Finance Company. Investment Bank, Discount House, Asset Management Company and a Venture Capital Company. 14. Other Form of Security means hypothecation of stock (inventory), assignment of receivables, lease rentals, contract receivables, etc. 15. Readily Realizable Assets mean and include liquid assets and stocks pledged to the banks in possession, with 'perfected lien' duly supported with complete documentation.

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16. Secured means exposure backed by tangible security and any other form of security with appropriate margins. Exposure without any security or collateral is defined as clean.

Risk Management Regulations

Risk Management Regulations lay down the minimum conditions for making investments, giving Loans, Advances and taking off-balance sheet exposures. There are Separate sets of R Regulations for:Corporate / Commercial Banking SMEs Financing Consumer Financing Micro Finance Banks Agriculture Financing

Risk Management
Corporate/Commercial Banking In order lo diversify the bank's exposure to a large number of clients, both individual and group, the Prudential Regulations provide that a bank/DFI can finance to the maximum extent of 30% and 50% respectively of its equity, as disclosed in their latest audited balance sheet. To further control the size of fund based finance, the eligible amount has been further reduced to the extent of 20% and 35% of the bank's equity.

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The exposure of contingent liabilities have also been controlled which shall not exceed at any point in time 10 times of Bank's equity.

Adjustments have been admissible to these entitlements to the extent of bank's lien/effective lien on credit balances, cash margin, unconditional financial guarantees and liquid securities held by the Bank.

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Lending to Corporate/Commercial Banking
Total Exposure from all banks ten times Companies equity Total Fund Based exposure 4times Companies equity. Current Ratio should not be less than Benchmark determined for particular industry by Bank Management. Banks can own shares in any company 5% of bank equity Total investment in shares 20% of bank equity.

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No borrower can avail exposure from all financial institutions more than 10 times of its own equity as disclosed in its last financial statements. This would include both funded and non funded exposure. The Fund Based Exposure with all banks will not exceed 4 times equity of Borrower. In exceptional cases (Seasonal Financing) Fund Based Exposure can go upto 8 times equity and total exposure can go upto 12 times.

Regarding guarantees, the SBP has been very particular by directing the banks not to indulge in this business except against 100% security out of which 20% will be in Liquid Assets as defined above.

WHAT IS CLASSIFICATION? WHAT IS PROVISIONING ?

Classification and provisioning made compulsory to laid down percentage Substandard. Where mark-up/ interest or principal is overdue by 90 days or more from the due date. Doubtful. above overdue by 180 days Loss (a) above overdue by one year. (b) Where Trade Bills (Import/Export or Inland Bills) are not paid/adjusted within 180 days of the due date.

Lending to Small and Medium Enterprise

Sources of Repayment have been Identified. Projected Cash Flow Statement Personal guarantees of owners directors compulsory Max exposure with all Banks not exceeding Rs 150 M Max exposure with a bank Rs 75M Total Clean Exposure Rs 3 M Clean Funded Facility Rs 2 M Declaration that no other clean facility taken from other banks.

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Aggregate exposure of a bank in SME linked with quality of overall SME lending If classification < 5% bank can finance any aggregate amount If classification Between 5 and 10% max aggregate 3 X equity If classification Between 10 and 15 % max aggregate 2 X equity If classification Above 15% max only upto equity. No financing to directors major share holders (above 5% holding) or their family members.

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Credit Information Bureau (CIB) Report Audited Accounts if exposure Rs 10 M or more. Loan Application + Borrowers Basic Fact Sheet. Classification provisioning same as in Corporate Commercial Financing

Corporate Governance:
Corporate Governance Criteria Appointment President/Chief Executive and Directors on the Board Role only policy, not day to day operations. Receives Management Letter from the external auditors, Action in consort with Internal Audit to remove/avoid observations. Banks to have themselves credit rated by approved Credit Rating Agency

KYC and Money Laundering

Know Your Customer procedures in place PR lay down docs required for a/c opening. Anti Money Laundering at Account Opening and onwards as a continuing process. Preservation of Record for generally 5 years depending on nature. a/c open forms held permanently. Reporting suspicious transactions to SBP without info to concerned customer.

Operations:
Restrained from window dressing. Reconciliation of Inter-branch and Suspense accounts - (30 days from entry date) Only less than 20% of Assets created against time and demand liabilities can be held abroad. All assets from sources other than time and demand liabilities should be in Pakistan.