The State Bank of Pakistan (SBP) on 21st January 2004, instructed banks and DFIs, that after 31-01-2004, the Karachi InterBank Offered Rate (KIBOR) of one, three & six-month tenor, and other longer tenors, shall be used as a benchmark rate for determining the pricing of all Rupee Corporate/Commercial banking lending, in terms of Prudential Regulations.
The decision has been made to encourage transparency, consistency in market based pricing and improve management of market risks undertaken by banks. The benchmarking was announced after a meeting between the SBP officials and the chief executives of all banks, under the Chairmanship of the Deputy Governor.
The banks have been advised to adhere to the procedure of benchmarking to KIBOR, with the following instructions:
1.THE BENCHMARKING WILL BE APPLICABLE TO: (i) All Floating and Fixed Rate Time Loans/TFCs/Commercial Papers with reset dates (where applicable) within the available KIBOR tenors up to 6 months, which is to be increased to 12 months by March 31, 2004 and thereafter to 3 years by December 31, 2004; and (ii) Overdraft and Running Finance obtained/renewed after 31 January 2004.
2.FOLLOWING METHODOLOGY WILL BE USED FOR USING KIBOR AS THE BENCHMARK RATE: (i) KIBOR is defined as the average rate, Ask Side, for the relevant tenor, as published on Reuters page KIBOR, or by the Financial Markets Association of Pakistan; (ii) Banks and the borrowers are free to decide on the relevant tenor of KIBOR and the spread over KIBOR at their discretion; (iii) KIBOR will be set, for lending on the date of draw-down or on the mark-up-reset date; and (iv) Offer Letter to the client should clearly indicate the KIBOR's tenor plus the agreed spread, frequency of revision etc.
3.FOLLOWING EXEMPTIONS WILL BE AVAILABLE FROM THE REQUIREMENT OF USING KIBOR AS BENCHMARK RATE: (i) Financing under Export Finance Scheme of the SBP, rates of which shall continue to be determined as per instructions issued by the Banking Policy Department of the SBP; (ii) Lending provided by the banks in terms of the Prudential Regulations relating to Consumer Financing and SME Financing; (iii) The Overdraft and Running Finance facilities extended up to 31 January 2004.
These shall, however, be benchmarked to KIBOR at the time of renewal of the facility or when the same is due for re-pricing; (iv) All TFCs/CPs approved by SECP and/or submitted to any stock exchange, provided the requests for necessary approval are submitted up to January 31, 2004, and (v) All time loans with agreements executed up to January 31, 2004.
However, if the pricing is renegotiated, these loans will be benchmarked to KIBOR.
The benchmarking of KIBOR is considered a major development in the financial market, with lasting beneficial impact on corporate lending practices, besides influencing the deposit rates used by banks to compensate different classes of depositors.
Through the spread or cushion over KIBOR, the banks would endeavour to recover all the elements of the cost of corporate lending, including the credit risk, for transactions with different borrowers.
The corporate borrowers are now expected to be more concerned about their corporate image, particularly their loan repayment performance, which would surely affect the spread over KIBOR.
Generally, the lower the credit rating of the borrowers, the higher would be the spread over KIBOR. Also, the longer the average maturity, there would be a higher spread over KIBOR.
The determination of the spread over KIBOR, or the range of minimum and maximum spread over KIBOR, would not be an easy task.
Many of the banks in Pakistan are said to be earning abnormally high intermediation cost or spread over KIBOR, generally in the range of 5 to 9% on annual basis.
However, in Pakistani conditions where 95% loan recovery is rarely achieved by some of the banks, such high spread might not be unjustified. Even if a particular bank specifies spread over KIBOR at 9% average on all loans and succeeds in recovering 95% of the loans due and the interest thereon, a major portion of the spread would be consumed in making up for the 5% loss - both of principal and the interest.
In addition, the bank would also be recovering their operating cost which might be between 1 to 2% of total assets.
On pre-tax profits, the bank are required to pay the government income taxes, which might range about 40%.
On this basis, the bank might be making about 1% net profit on assets. However, in case loan recovery falls below 95% or the spread over KIBOR is reduced substantially below 9%, the banks may go in red.
The spread at 9% over KIBOR, whatever the justification, would not be sustainable. One could argue that the credit risk element used in the spread might be determined, based on future prospects of debt-servicing, and not on the basis of past experience when loan losses were high.
This situation, particularly for the Pakistani public sector banks and DFIs, would be further complicated when foreign banks operating in Pakistan might offer corporate loans with spread of say 250 basis points or 2.50% over KIBOR, as these banks deal with only highly credible clients and their loan losses in the past were minimal.
Therefore, most of the local banks shall have to considerably improve their loaning practices and procedures. Now they shall have to rank the credibility and debt-servicing capability of different borrowers and set the spread over KIBOR accordingly.
The cost of borrowings for companies that are not profitable or well-known is high. Corporate borrowers should reduce their cost of production; improve productivity and profitability to be able to borrow at a lower spread. Intermediation cost or spread over KIBOR can be brought down if corporate borrowers show better performance by maintaining repayment nearly 100% and the banks, by reducing their operating costs.
There are possibly 15-20 other banks and DFIs offering similar loan facilities to the corporate sector.
All financial institutions would be vying for establishing business relationships with companies having better credit ratings, profitability and corporate image.
Good borrowers wish to deal with banks offering relatively cheaper credits and better services.
The desire to attract good business with credible customers would keep major banks on their toes by cutting costs, improving efficiency and quality of their service. KIBOR is expected to be used more by the foreign banks operating in Pakistan.
In their world-wide operations they are mostly using benchmarks such as LIBOR and proper systems are already in place. The local banks should expect tough competition for attracting credible customers.
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