Prudential Regulations 8 Classification & Provisioning
Listen The Article
Prudential regulations play a crucial role in maintaining the stability and soundness of the banking sector. Among these regulations, Prudential Regulation PR-8 stands as a fundamental framework for the classification and provisioning of assets within banks and development financial institutions (DFIs).
PR-8 provides guidelines and criteria for the proper assessment, classification, and provisioning of loans, investments, and other assets, ensuring accurate risk evaluation and financial reporting.
a) Banks/DFIs must follow the prudential guidelines outlined in Annexure-V when classifying their asset portfolio and making provisions based on time criteria.
b) Apart from the criteria outlined in Annexure-V, it is essential to conduct a subjective assessment of both performing and non-performing credit portfolios to evaluate risks.
If deemed necessary, any account, even if it is currently performing, may be classified and further downgraded based on the time-based criteria.
This evaluation should consider factors such as the borrower’s creditworthiness, cash flow, account operations, adequacy of security (including its realizable value), and documentation pertaining to the advances.
Annexure V – PR 8
Guidelines in the matter of classification and provisioning for assets
All Financing Facilities (including short, medium and long term)
|Classification||Determinant||Treatment of Income||Provisions to be made|
|Substandard||When mark-up/interest or principal is overdue by 90 days or more from the due date.||Unrealized mark-up/interest should be recorded in a Memorandum Account and not credited to the Income Account, except when realized in cash.|
Any previously recognized unrealized mark-up/interest should be reversed and kept in the Memorandum Account.
|Provision of 25% should be made based on the difference between the outstanding principal balance and the amount of liquid assets that can be realized without resorting to a Court of Law, as well as the Forced Sale Value (FSV) of pledged stocks, plant & machinery under charge, and mortgaged residential, commercial & industrial properties (land & building only) within the limits specified in Para 2 of Regulation R-8.|
|Doubtful||When mark-up/interest or principal is overdue by 180 days or more from the due date.||Same treatment as for the Substandard category.||Provision of 50% remaining wordings are same as above.|
|Loss||(a) When mark-up/interest or principal is overdue by one year or more from the due date.|
(b) When Trade Bills (Import/Export or Inland Bills) are not paid/adjusted within 180 days from the due date.
|Same treatment as for the Substandard and Doubtful categories.||Provision of 100% remaining wordings are same as above.|
The Benefits of Collateral/Security Held:
a) Banks/DFIs have the option to utilize the Forced Sale Value (FSV) of pledged stocks, plant & machinery, and mortgaged residential, commercial, and industrial properties held as collateral against Non-Performing Loans (NPLs) for the purpose of calculating provisioning requirements as detailed in the provided table.
However, this benefit of FSV against NPLs is only applicable within the specified time period. To determine the FSV, banks/DFIs should refer to Annexure-VI of PR for Corporate/Commercial Banking.
|Category of Assets||FSV benefit allowed from the date of classification|
|Mortgaged residential, Commercial and Industrial Properties (Land & Building only)||- 75% for 1st year
- 60% for 2nd year
- 45% for 3rd year
- 30% for 4th year
- 20% for 5th year
|Plant and Machinery under charge||- 30% for 1st year
- 20% for 2nd year
- 10% for 3rd year
|Pledged Stock||- 40% for 1st, 2nd and 3rd year|
Annexure VI – PR 8
Uniform Criteria for Determining the Value of Pledged Stock, Plant & Machinery under Charge, and Mortgaged Properties (Prudential Regulation R-8)
To ensure consistent standards, the valuation of assets such as liquid assets, pledged stock, plant & machinery under charge, and mortgaged properties is governed by the following criteria:
Eligibility for Provisioning Benefit:
Only liquid assets, pledged stock, plant & machinery under charge, and properties with registered or equitable mortgages are considered for provisioning, provided no No Objection Certificate (NOC) for creating further charge has been issued by the bank/DFI. Assets with pari-passu charge are considered on a proportionate basis of the outstanding amount.
Exclusions from Provisioning Benefit:
Hypothecated assets, excluding plant & machinery under charge, as well as assets with a second charge or floating charge, are not eligible for the Fair Value benefit for provisioning requirements.
An independent professional evaluator listed on the Pakistan Banks Association (PBA) panel should conduct valuations.
The evaluator considers relevant factors such as the assets’ salability, difficulty in obtaining possession, location, condition, and prevailing economic conditions in the relevant sector.
The values assigned to pledged stock, plant & machinery under charge, and mortgaged property must reasonably estimate the amount that could be obtained in a forced or distressed sale.
The evaluator’s report should mention assumptions, calculations, formulas, and the method used to determine Market Value and Forced Sale Value (FSV).
The valuation process involves a “Full-scope Valuation” in the first year and subsequent “Desktop Valuations” in the second and third years.
A Full-scope Valuation is valid for three years from the date of the last Full-scope Valuation.
Desktop and Full-scope Valuations:
An interim review of the Full-scope Valuation, accounting for any significant changes in the factors considered. For loans exceeding Rs 100 million, the same evaluator who conducted the Full-scope Valuation should perform the Desktop Valuation.
For loans below this threshold, banks/DFIs may conduct the Desktop Valuation themselves or engage approved evaluators. The evaluator makes a brief visit to the borrower’s site, and the bank/DFI ensures necessary information is provided for the interim review.
Use of Valuations:
Desktop Valuations determine additional provisioning requirements but cannot reduce the provisioning requirement assessed based on the Full-scope Valuation. If evaluators are denied access to the borrower’s premises, the Full-scope Valuation conducted under such conditions is not accepted for provisioning benefit.
Verification by State Bank of Pakistan:
The State Bank of Pakistan may conduct random verifications of the valuations of mortgaged/charged assets through an independent evaluator to ensure their reasonableness.
Unjustified differences between the valuations of banks/DFIs and the State Bank of Pakistan may result in penal actions, including withdrawal of FSV benefit.
Categories of Assets for Valuation:
Only the following categories of assets are considered for valuation:
The bank/DFI determines the valuation of liquid assets, which is verified by external auditors. Pledged shares of listed companies are valued at the market value as per active lists of Stock Exchange(s) on the balance sheet date. Shares pledged against loans/advances are considered only if they are in dematerialized form in the Central Depository Company of Pakistan (CDC).
Mortgaged Property and Plant & Machinery under Charge:
Residential, commercial, and industrial property (land and buildings) and plant & machinery are valued by evaluators based on the provided criteria.
Evaluators provide forced sale values for pledged stocks of perishable
b) Banks/DFIs can avail of the aforementioned benefit of FSV by adhering to the following conditions:
i) The additional impact on profitability resulting from utilizing the benefit of FSV cannot be utilized for the payment of cash or stock dividends/bonuses to employees.
ii) The Heads of Credit in their respective banks/DFIs have the responsibility to ensure the accurate determination of Forced Sale Value (FSV) for provisioning benefits, following the guidelines provided in the Prudential Regulations (PRs). It is crucial that the FSV accurately reflects market conditions in forced sale situations.
iii) Comprehensive documentation of all instances where banks/DFIs have utilized the advantage of FSV, categorized by individual borrowers, should be meticulously maintained for review by the State Bank’s inspection team during routine or special inspections.
c) Any occurrences of improper utilization of the FSV advantage uncovered during regular or special inspections carried out by the State Bank will lead to rigorous punitive measures in accordance with the applicable provisions of the Banking Companies Ordinance, Additionally, the State Bank reserves the right to withdraw the benefit of FSV from any bank/DFI found to be involved in its misuse.
a) Banks/DFIs have the flexibility to reschedule/restructure loans according to their policies.
However, the purpose of rescheduling/restructuring should not solely be to avoid classification. The classification status of a loan/advance will not change unless the terms and conditions of rescheduling/restructuring are fully met for a minimum period of one year (excluding any grace period) from the date of such action.
Additionally, at least 10% of the total restructured loan amount (principal + mark-up) must be recovered in cash. It’s important to note that if the borrower repays or adjusts at least 35% of the total restructured loan amount in cash, either during the restructuring agreement or later within the grace period, the requirement of a one-year retention period for remaining in the classified category does not apply.
b) The unrealized interest on loans that have been reclassified following rescheduling or restructuring should not be accounted for in the income statement unless a minimum of 50% of the outstanding amount is recovered in cash.
However, if all other criteria, including adherence to terms and conditions for a minimum of one year and payment of at least 10% of the outstanding balance by the borrower, are met, any deficiency in recovery will not affect the reclassification of the account.
Banks/DFIs are advised to ensure that the classification status and provisioning remain unchanged in the reports submitted to the State Bank of Pakistan, even in cases of loan rescheduling or restructuring. However, when reporting to the Credit Information Bureau (CIB) of the State Bank of Pakistan, such loans/advances may be identified as “rescheduled/restructured” instead of “overdue.”
c) If a borrower defaults on either the principal or mark-up after the loan has been declassified following rescheduling/restructuring, the loan will be reclassified in the same category as it was at the time of rescheduling/restructuring.
Additionally, the unrealized markup on such loans, which had been included in the income account, will be reversed. However, banks/DFIs have the authority to lower the classification based on their own judgment and subjective criteria.
d) During the rescheduling/restructuring process, banks/DFIs must carefully consider and evaluate requests for working capital, taking into account the viability of the project/business and appropriately securing their interests.
e) New loans extended by banks/DFIs to a borrower subsequent to the rescheduling or restructuring of existing facilities must be subject to separate monitoring and tracking.. These loans will be subject to classification under this Regulation based on their specific terms and conditions.
Investments and Other Assets:
Banks are required to classify their investments into three categories: ‘Held for Trading’, ‘Available for Sale’, and ‘Held to Maturity’.
Investments in subsidiaries and associates are reported separately following applicable International Financial Reporting Standards in Pakistan and are not subject to mark-to-market valuation.
Regular impairment testing should be conducted for all investments and other assets. The classification of the investment portfolio in ‘Held for Trading’ and ‘Available for Sale’, as well as other assets, should be evaluated based on various subjective and objective factors, which are as follows:
a) Quoted Securities:
Government securities are valued based on PKRV (Reuter Page). TFCs, PTCs, Sukuk, and shares are valued at their market value. The difference between the market value and book value is considered as surplus or deficit.
b) Unquoted Securities:
PTCs, TFCs, and Sukuk are classified based on repayment defaults, following the criteria for classifying medium and long-term facilities.
Shares are carried at cost. However, if the breakup value of these shares is lower than the cost, the difference between the cost and breakup value is classified as a loss and provided for accordingly by charging it to the bank/DFI’s Profit and Loss account.
c) Treatment of Surplus/Deficit:
Surplus or deficit is measured on a portfolio basis in accordance with BSD Circular No. 10 of 2004, as amended.
The surplus or deficit arising from the revaluation of ‘Held for Trading’ securities is accounted for in the Profit and Loss Account. Surplus or deficit from the revaluation of ‘Available for Sale’ securities is accounted for under “Surplus/Deficit on Revaluation of Securities” in the Statement of Comprehensive Income, and not in the Profit and Loss Account.
Impairment in the value of ‘Available for Sale’ or ‘Held to Maturity’ securities is provided for by charging it to the Profit and Loss Account.
d) Other Assets:
Classification of other assets and the necessary provisions should be determined based on the risk involved and the requirements of International Financial Reporting Standards.
Timing of Creating Provisions:
Banks must review the collectability of their loans/advances portfolio on a quarterly basis and properly document the evaluations. Any shortfall in provisioning resulting from the quarterly assessment should be immediately provided for in the banks’ books of accounts on a quarterly basis.
Reversal of Provision:
In the case of cash recovery, banks/DFIs may reverse specific provisions held against classified assets, provided that the provisions are maintained in accordance with Annexure V.
However, accounts classified and provisioned based on the advice of the State Bank of Pakistan cannot be declassified or have provisions reversed without prior approval from the State Bank, except in cases where cash recovery has been made through the customer’s own sources, as long as the remaining provisions are maintained as per regulations.
Verification by the Auditors:
During their annual audits of banks/DFIs, external auditors should verify compliance with all requirements of Regulation R-8 for asset classification and provisioning. The State Bank of Pakistan also assesses the adequacy of provisioning during on-site inspections.