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.