Banks are ready to use KIBOR, or Karachi inter-bank offered rate, as a reference rate for pricing corporate loans. The State Bank of Pakistan (SBP) persuaded all local and foreign banks to do this to make the interest rate structure more market-based.

The central bank and the Pakistan Banks Association recently issued a joint statement in this regard. The statement said that banks would start using KIBOR as a reference rate for corporate customers' lending in rupees from February 1, 2004.

KIBOR came to the fore in September 2001, when some major local and foreign banks took up the challenge of creating a market-based benchmark for interest rates. These banks started quoting inter-bank lending and borrowing rates on daily basis. Reuters used these rates for working out KIBOR and KIBID or Karachi inter-bank bid rates and started flashing them across the world.

Since KIBOR reflected the average interest rate at which some banks of the KIBOR club were willing to lend money to other banks of the club, it was much lower than the average customers' lending rate.

Top businessmen soon took notice of it, and some of them started demanding the banks to link their customers' lending rates with KIBOR. But banks refused to do this because the determinants of the inter-bank lending rates and customers' lending rates were very different.

The launch of KIBOR had, however, set the stage back in September 2001 for the interest rates to become market-based though its scope was limited to the inter-bank market.

Then in December 2001, the government introduced Pakistan Investment Bonds. The basic purpose of launching these three-year, five-year and 10-year bonds was to establish a long-term curve so that corporates can price their debt-raising instruments accordingly. These scripless bonds carried a fixed coupon rate but their yields were to be determined according to their demand and supply. The bonds did meet their objective and their cut-off yields soon became a benchmark for corporates to price their term finance certificates. So, whereas KIBOR set a reference rate for clean inter-bank lending, PIBs became a benchmark for secondary market debt raising by the close of 2001.

In the year 2002 the respective status of KIBOR and PIBs strengthened further. Moreover, as anticipated by the policy makers both also started reflecting changes in the monetary policy, to a certain extent, in their respective areas.

The SBP also wanted the banks to come up with some benchmark for customers' lending rates to ensure that the changes in monetary policy have a desired impact on the price of corporate finance without delay.

In July-October 2001 the SBP had cut its discount rate by four percentage points to 10 per cent in three instalments to revive the economy, but this had failed to bring about the desired change in the banks' lending rates structure.

That prompted the SBP to see what had gone wrong and where. The central bank found that the primary reason for the banks not responding properly to the changes in the monetary policy was the absence of a benchmark for their customers' lending rates.The SBP found that this was also a key reason for the rising gap between the banks' lending and deposit rates.

The gap between the weighted average lending and deposit rates of all banks combined had risen from 8.13 per cent in fiscal year July/June 1999/00 to 8.74 per cent in 2000/01, bringing into question the World Bank-sponsored banking reforms that had rendered thousands of bankers jobless.

In November 2001, the SBP had set up a committee of top bankers drawn from both local and foreign banks for identifying and developing a benchmark for banks' customers' lending rates. The committee headed by the Country Manager, ABN AMRO, Mr. Naved A. Khan, initially tried to convince banks to develop their prime lending rates for this purpose.

The committee then believed that it would also be easier for the banks to reflect changes in the SBP monetary policy through their prime lending rates rather than by making across-the-board changes in their overall lending rates structure. The term prime lending rate refers to the lending rates at which banks lend money to their first class borrowers.

But the committee had to drop this idea because opinions were sharply divided on this issue: whereas foreign banks having small branch networks and smaller portfolios of bad loans found the idea feasible, local banks did not.

Local banks particularly those with large branch networks and huge portfolios of bad loans opposed the idea because their cost of financial inter-mediation was much higher than that of the foreign banks. So, they would have found it difficult to compete with foreign banks, had the concept of prime lending rates been materialized. It took the committee more than a year to develop a consensus alternative and finally all the banks agreed in January 2004 to use KIBOR as a benchmark for corporate lending rates.

From February 2004, banks will be in a position to quote mark-ups on corporate finance by adding a few percentage points on KIBOR of similar tenure. Since they are supposed to extend the KIBOR tenure to one year by March 31, 2004 they will initially be quoting corporate finance mark-ups by using KIBOR for one-month to six-month.

Senior bankers say they do not expect many corporates to take advantage of this facility before March 2004 because it will take them time to get familiar with the KIBOR-based mark-up rates. But top corporates including multinationals seem ready to avail of this facility, as they are familiar with market-based lending rates' mechanism due to exposure in local and foreign secondary debt markets.

Moreover, the use of KIBOR as a benchmark for bank customers' lending will initially remain limited to corporate finance only. It will not apply on (i) export finance and (ii) consumer financing and lending to small and medium enterprises. It will also not apply on (iii) overdrafts and running finance facilities existing before January 31, 2004, (iv) term finance certificates/commercial papers approved by the SECP or submitted to any stock exchange before January 31, 2004; and (v) all term loans with the agreements executed before January 31, 2004. Export finance rates will continue to be determined by adding a spread of 1.5 percentage point on the SBP refinance rate that is linked with the cut-off yield on six-month treasury bills.

As for consumer financing and lending to SMEs, banks will determine the mark-ups keeping in view their own cost of funds and the risks involved in such financing besides meeting the requirements of SBP's Prudential Regulations for both.

So, initially the use of KIBOR as a reference rate would not benefit a large number of bank clients. That is why, many business leaders have their reservations over the SBP-PBA decision to introduce KIBOR as a benchmark for banks' customers' lending without taking the business community into confidence. They say that SBP-PBA should have consulted them because the business community is the equal stakeholder in every monetary move-the central bank and banks being the other two important stakeholders.

As for depositors, an efficient use of KIBOR by the banks for benchmarking their corporate loan prices may reduce their operational costs and create room for them to improve the rates of return on deposits. But that may take the banks quite some time.

In the meantime, the sufferings of the depositors do not seem to be over in near future, also because of the fact that banks' lending rates have started inching up after having bottomed out in August 2003. At the end of November 2003, weighted average lending rate of all banks combined rose to 5.49 per cent from 5.02 per cent at the end of August.

But the combined weighted average deposit rate of all banks declined to 1.47 per cent at end-November from 1.6 percent at end-August 2003. Given the fact that annualized CPI inflation was up 2.62 percent in July-November 2003 compared with a year-ago period, the average deposit rate of 1.47 per cent was not only negative it was at its humiliating low.