Banks urged to be wary of sovereign loan defaults

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The State Bank of Pakistan has asked commercial banks to start taking into account the probability of default on loans taken out by the federal government. This ends the decades-old belief that the government cannot default on domestic debt.

The central bank issued the International Financial Reporting Standards (IFRS-9) instructions and removed an expected credit loss exemption on federally guaranteed or contracted loans, the July 2021 instructions revealed. be applied with effect from January 1, 2022.
IFRS-9 is the set of accounting rules that specify how a bank should classify and measure financial assets and financial liabilities.

According to an SBP circular from July 2021, these instructions will be applied from January 1, 2022 and the central bank has not issued any new orders to extend the deadline. The SBP instructions would also limit banks’ ability to lend to the government indefinitely in addition to increasing the cost of borrowing. The application of the six-month-old decision would coincide with the absolute autonomy given to the SBP, including a ban on the government borrowing from the central bank.

The new regulations will force banks to review their capital requirements and increase money in proportion to the weighted risks given to public loans. In its official response, the SBP said there would be some impact on the capital adequacy ratio due to the new regulations, but it “will be negligible”. He also said the expected credit loss on loans to the federal government would not be “substantial.”

“The SBP should not have put in place new regulations on the banking sector at this stage, because the country’s financial situation is already not very stable and it will be even more disturbed because of this,” said Shabbar. Zaidi, former senior partner at AF Ferguson. . “Because of the new regulations, the cost of government borrowing will increase significantly,” he added, demanding that the SBP withdraw the new measures.

Under the 2019 IFRS-9 regulations, commercial banks had been exempted from imposing a capital charge on loans made to the federal government. To allow this exemption, there was a clause in the old IFRS-9 regulation which read as follows: “The credit risk [in local currency] which have been guaranteed by the government and government securities are exempt from the application of the expected credit loss model and would not require provisioning.

The July 2021 instructions revealed that the SBP had removed this clause. This means that there is now a probability of default on loans to the federal government, which would eventually force commercial banks to set aside provisions for any expected losses. The removal of this clause means that banks must now calculate the 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 five largest banks. As a result, these exposures often have very fine pricing, reflecting the perceived low risk, he added. The bank’s written comments further showed that while the ultimate recovery of the loan was assured and therefore any loss would still be considered nil, there would still be the impact of the time value of money.

The decision becomes particularly relevant given the frequent restructurings in these exposures, especially in the case of the electricity sector. Banking industry players said similar exemptions had been granted on government loans in other countries where IFRS was applicable, demanding the reinstatement of the exemption facility. Banks will now have to calculate the expected credit loss on Pakistan’s treasury bills and investment bonds.

“This means it will attract capital charges for banks and hamper their ability to hold unlimited government debt,” a Karachi-based banker told The Express Tribune. He said that regardless of prevailing interest rates, banks would not be able to buy government debt above a certain threshold.
“The SBP would be prevented by the new law from lending to the government, so who will finance the budget deficit in one to two years?” he asked.

Banking industry experts said factoring in expected credit loss would mean there was a likelihood of default and banks would have to raise the capital adequacy ratio, which would cost them dearly.
“No bank will bear the cost on its books without first recovering from the government by raising lending rates,” said another banker. After the ban on the government borrowing from the central bank, the federal government can only meet its financing needs from commercial banks. According to another amendment to the SBP bill that the National Assembly approved last week, the primary objective of the SBP will be domestic price stability.

Finance ministry sources said the central bank could end inflation control if the government remains reckless in its debt-financed spending. This can then create problems for the government. Asked about the implementation of IFRS9 by January 1, 2022, SBP Chief Spokesperson Abid Qamar said the central bank was in consultation with the banking industry and received their feedback. on the draft guidelines published on July 5, 2021.

Qamar added that based on feedback received from the banking industry, the IFRS-9 guidance and implementation date is currently under review. “It will be communicated to the industry in due course.” However, to date, the central bank has not granted an extension to the implementation date. The sources said banks had started preparing their balance sheets under new regulations.
Asked why the SBP removed the clause, the spokesperson said that these draft instructions are in line with the principles of the IFRS-9 accounting standard and global best practices.

“The reason for removing the clause is that the expected credit loss on government exposure is not substantial. Therefore, removing this clause would have no material impact,” he added. .
However, the response suggests that the SBP expects some credit loss but continues to maintain it “is not substantial.” To another question on the implications of the new regulations on the government’s cost of borrowing, the spokesperson said they were of the view that there would be no further impact on the cost of government loan.

However, the spokesperson agreed that banks’ capital adequacy ratio requirements would increase, but “there will be a very negligible impact on banks’ capital adequacy ratios.” Although the new regulations imply that sovereign loans could default, Qamar said “that assumption is incorrect.”