State Bank of Pakistan (SBP) has re-defined the limits of credit that banks may extend to individual business entities and groups. Quite sensibly, the cutting of exposure (loan less collateral value) is to be completed in the next five years giving banks and borrowers time to absorb the impact of the change.

The regulation does not envisage a reduction in lending to individual entities. In fact, in 2013 SBP envisages raising the exposure limit for individual entities from the present 20 per cent of the banks’ unimpaired equities (i.e. equities net of loan losses), to 25 per cent. However, the regulatory shift requires banks to cut their risk on group companies, which is a significant development.

This is probably due to banks’ recent experience of lending to company groups that together performed below expectations because they were led by boards of directors dominated by particular investors groups that unsuccessfully implemented overly optimistic business agendas. By 2013 the now permitted total funded and non-funded exposure of 50 per cent on groups of companies must fall to 25 per cent.

By implication, SBP requires banks to diversify their risk portfolios in terms of borrowers and limit the accumulation of wealth in few hands. Besides, with bank equities bound to rise as per the equity injection plan given by the last SBP governor, exposures as reduced percentages of equities, should not reduce credit to the private sector; with larger bank equities, hopefully, even reduced exposure limits could suffice.

But will banks succeed in meeting the capital injection targets assigned to them for 2009 and 2010? Will banks’ operating results in these years remain impressive in spite of the global economic slowdown and its fallout in the shape of loan delinquencies? Besides, will it not take time for investor confidence to revive courtesy the ongoing frightful downturn at stock markets? All these are big question marks.

On August 29, 1992, when SBP initially imposed a diluted version of the Basle Accord-I in the form of ‘Prudential Regulations’, banks were permitted to take exposure on borrowers only up to 10 per cent of banks’ unimpaired equities. In 1997 in a meeting in SBP wherein banks presented their input for revising the 1992 version of the Prudential Regulations, there was disagreement over defining a ‘subsidiary’.

As per financial accounting standards, even a company wherein the holding company held just 20 per cent shares but had substantial influence in its management was to be treated as its subsidiary but this view was rejected. But by end-2003 things changed. For groups, the exposure limit was raised to 50 per cent of bank’s unimpaired equity courtesy the post-9/11 foreign inflows that banks didn’t know how to deploy.

Today, however, the presence of common directors on the boards of two companies is enough to treat them as ‘group’ companies without one company owning shares of the other. This is very prudent but how banks fare in implementing it is doubtful since directors could resign anytime changing a company’s status from ‘group’ to ‘individual’ while exposure on it may be above the limit for individual companies.

In recent years, more than one industrial group together financed by several banks ran into trouble. While weakening of some vulnerable groups following global markets’ meltdown may make sense it isn’t forgivable because banks lending to them in a big way, were obliged to track the prices of commodities/ inputs these companies imported and the foreign markets to which they exported their finished goods.

It reflects a grave weakness: none or only ceremonial in-house risk-oriented research, or depending on other banks for risk investigation and assessment. In some cases, it seems that no lending bank took this trouble; they all assumed the others to have done that crucial exercise. Therefore, cutting exposure limits without imposing a strict investigative discipline may not reduce loan delinquency to a tolerable level.

Bankers privately admit that banks’ frontlines lack the necessary investigative and managerial skills that are essential during recessions when risk impacts even well-managed enterprises. Only few banks have in-house facilities for staff training based on case studies. Surely, SBP keeps track of banks’ employee skill development efforts. Given such surveillance, the scenario should have been more reassuring than it is.

The move to cut to half (by 2013) risk exposures on groups of companies also implies that risk investigation (assisted by credit information bureaus and rating agencies) and assessment (by banks internally) remains weak even after 16 years of promulgating the Prudential Regulations, due to the inadequacy of institutional arrangements there for – all true beyond doubt.

Experience proves that, in isolation, regulation does not deliver; it must be supplemented by both pressure and encouragement to ensure that skills are developed to assure implementation of regulation in letter and spirit. In recent years, focus on building in-house risk management capacity was visibly sidelined. Instead, a sort of ‘piracy’ wherein banks enticed good employees of their competitors to join them was relied on.

Cutting down exposure limits is a wise step given the tough times ahead but it must be supplement by substantially improved regulation that obliges banks to manage risk far better. This is the message of the chaos that we witness all over the world. Regulation was inadequate and weak but supervision to verify its implementation was weaker, and reporting requirements obliged banks to tell only partial truths.

This scenario must change. Banks must be encouraged to set up in-house market risk research units and spend more time and effort on niche-based employee skill development. Alongside this effort, SBP must also re-examine the efficacy of the presently available institutional arrangements – credit referencing and information, risk rating, and external audit – without which banks cannot manage risk effectively.

Reduced lending per entity (the most likely outcome of the new regulation given the doubts about banks’ ability to inject more capital) can’t make up for the critical gaps in risk management referred to above. What we need is a shift in quality that won’t be possible unless we address the real issue. Unfortunately, the post-9/11 easy availability of liquidity diluted the importance of quality in risk management.

Finally, it is also time to make banks realise that the need of the hour is the revival of the economy; profit making must be postponed for a while to permit the maximum number of troubled businesses to survive until things improve. In any case, banks made unrealistically high profits in the past five years.