The State Bank of Pakistan has instructed commercial banks to start taking into account the probability of default on loans taken by the federal government. This brings an end to the decades-old belief that the government cannot default on domestic debt.
The central bank has issued the International Financial Reporting Standards (IFRS-9) instructions and withdrew an exemption from the expected credit loss on loans either guaranteed or taken by the federal government, revealed the July 2021 instructions that were to be enforced with effect January 1, 2022.
The IFRS-9 is the set of accounting rules that specify how a bank should classify and measure financial assets and liabilities.
According to a July 2021 SBP circular, these instructions were to be enforced with effect from January 1, 2022, and the central bank has not issued any new order to extend the deadline. The SBP’s instructions would also limit the banks’ ability to extend an unlimited amount of loans to the government besides increasing the cost of borrowing. The enforcement of the six-month-old decision would coincide with the absolute autonomy being given to the SBP, including a prohibition on the government borrowing from the central bank.
The new regulations will force the banks to review their capital requirements and increase the money in proportionate to the weighted risks being given to the government loans. The SBP said there would be some impact on the capital adequacy ratio because of the new regulations but it “will be negligible”. It also said that the expected credit loss on lending to the federal government would not be “substantial”.
“The SBP should not have implemented new regulations on the banking sector at this stage, as the country’s financial position is already not very stable and it will be disturbed even more because of this,” said Shabbar Zaidi, a former senior partner of AF Ferguson. “As a result of the new regulations, the cost of government borrowing will significantly increase,” he added, demanding that the SBP should withdraw the new measures.
According to IFRS-9 regulations of 2019, commercial banks had been given an exemption from making a capital charge on loans given to the federal government. To enable this exemption, there was a clause in the old IFRS-9 regulation that reads: “The credit exposure [in local currency] that have been guaranteed by the government and the government securities are exempted from the application of expected credit loss model and would not require provisioning.”
The July 2021 instructions revealed that the SBP had deleted this clause. This means that there is now a probability of default on the loans given to the federal government, which would eventually force commercial banks to make provisions against any expected loss. The deletion of this clause implies that the banks now need to calculate expected credit loss on these exposures.
This has huge implications for the industry, which considers government exposures to be credit risk-free, according to one of the country’s top five banks. As a result, these exposures often carried very fine pricing, reflecting the low perceived risk, it added. The bank’s written comments further showed that while the ultimate recovery of the loan was assured and hence any loss would always be considered zero, there would always be the impact of the time value of the money.
The decision becomes especially relevant considering frequent restructuring in these exposures, especially in the case of the power sector. The banking industry players said that similar exemptions had been given on the government lending in other countries where the IFRS was applicable, demanding restoration of the exemption facility. The banks will now need to calculate expected credit loss on the treasury bill and Pakistan Investment Bonds.
“This means that this will attract a capital charge for the banks and impede their ability to hold unlimited government debt,” a Karachi-based banker said. He said that irrespective of the prevailing interest rates, the banks would not be able to buy the government debt beyond a threshold.
“The SBP would be stopped by the new law from lending to the government so who will fund the budget deficit in one to two years’ time?” he questioned.
Banking industry experts said taking expected credit loss would mean that there was a probability of default and the banks will have to increase the capital adequacy ratio, which will carry a cost to them
“No bank will bear the cost on its books without first recovering from the government by increasing the lending rates,” said another banker. After a ban on the government borrowing from the central bank, the federal government can only meet its financing needs from the commercial banks. According to another amendment in the SBP bill that the National Assembly approved last week, the SBP’s primary objective will be domestic price stability.
Finance ministry sources said the central bank could pull a plug in the name of controlling inflation if the government remained imprudent in its debt-financed spending. This can then create problems for the government. To a question about the implementation of the IFRS9 by January 1, 2022, SBP chief spokesperson Abid Qamar said that the central bank was in consultation with the banking industry and had received feedback from them on the draft guidelines issued on July 5, 2021.
Qamar added that keeping in view the feedback received from the banking industry, the IFRS-9 instructions and implementation date were currently under review. “It will be communicated to the industry in due course of time.” However, as of now, the central bank has not given an extension in the implementation date. The sources said the banks had started preparing their balance sheets under new regulations.
To a question why the SBP deleted the clause, the spokesperson said these draft instructions were in line with IFRS-9 Accounting Standard Principles and Global Best Practices.
“The rationale for deleting the clause is that the expected credit loss on exposure to government is not substantial. Hence, the deletion of this clause would not have any material impact,” he added.
However, the reply suggests that the SBP expects some credit loss but continues to maintain it “is not substantial”. To another question about the implications of the new regulations on the government’s borrowing cost, the spokesperson said they were of the view that there would be no additional impact on the government’s borrowing cost.
However, the spokesperson agreed that the banks’ capital adequacy ratio requirements would increase but “there will be very negligible impact on the Capital Adequacy Ratios of the banks”. Although the new regulations imply that sovereign loans could default, Qamar said “this assumption is incorrect”.