Research has long noted lack of scale in Pakistan’s corporate firms as one reason for their lack of competitiveness in foreign markets. Often, this is seen as a response to exogenous forces that keep corporations from flourishing: scarce availability of capital for expansion is often cited as one cause, as is the prying eye of the taxman.
However, often missed is the preference of private-limited and seth-led firms to keep their ‘setup small’, making lack of scale a conscious choice rather than an inevitability of circumstances. This is often characterized by fragmenting operations that should fall under same business line into separate corporate entities.
Such fragmentation often reaches comical proportions, such as managing three physically distinct textile units falling under the 5-sq. mile radius of Korangi industrial area under separate SECP registrations (all engaged in fabric weaving!). Of course, privately held companies find it easier to get away with these gimmicks compared to listed firms. But to what end?
A quick survey of lending by corporate arms of most banks would reveal that more than two-third obligors are private limited, even if in value terms most of the borrowing is concentrated with large listed firms. For banks, thus, private limited obligors often represent a plenty but messy bunch.
This has led to a long standing (and successful) practice of grouping exposure to corporate borrowers by sponsor families, rather than types of business. Loan applications from prospective borrowers are graded based on factors such as sponsor’s financial health and liquidity, past record with bank/s, instead of purely on business plan or projections.
Subjective factors, of course, can be critical, as financial fundamentals cannot fully capture information about borrower’s willingness to repay or likelihood of willful default. The success of this two-pronged reliance on sponsor profile as much as on financials can be gauged by the low infection ratio in banking sector’s corporate lending portfolio.
Except, as most corporate bankers and risk managers would privately vouch, the decision-making criteria is heavily skewed in the direction of sponsor profile alone. Often, lending decision is based on senior management’s relationship with members of sponsor family, and risk managers are expected to ‘draw comfort’ from it, especially where financials present a weak case.
And rationally too! As the approach proves effective far more times than not. If the sponsor is as good as his word, he makes timely payments even if the borrowing firm is bleeding money. So where lies the rub?
Banks’ comfort with the sponsors makes it ever-increasingly less reliant on financial information, reducing the borrower’s incentive to make regular, accurate and timely disclosures; creating a moral hazard. Let’s illustrate with evidence. Short-term lending to firms is often extended against a “hypothecation charge over current assets”. By definition, the nature of such collateral is floating. A regular customer may borrow against same current assets from several lenders. So far, all kosher.
Except, banks have nothing except a monthly ‘stock statement’ filing to go by to check whether their exposure is covered by asset position. This statement is filed separately with each bank, allowing possibility of varied reporting, such that numbers for each may add up. And rules of competition dictate that rival lenders rarely run this information by each other.
Unlike listed firms that release quarterly statements, private limited firms are only required to share financials with lenders on annual basis, and that too within six months of year-end. This means that banks have no way of cross checking their exposure, except rely on good-faith of sponsor’s trust.
The lines between routine business and ethically grey areas especially begin to blur when sponsors run several units within same business segment under different corporate entities. Take the example of a group with distinct units for spinning, weaving, and garments.
Even if virtually all sales of spinning and weaving units are inter-segment, keeping them as distinct corporate entities allows the sponsor to enjoy three times the borrowing capacity compared to if the businesses were vertically integrated into one firm.
And then there is outright disingenuity. When pre-shipment loans are extended against same contracts presented at two different banks, swapped later at the time of export receipt realization. Or, when short-term lines of a dairy business are utilized to make salary payments to employees of a textile arm. “Sponsor’s comfort” allows the bankers to ignore what goes on right under their noses. As long as payments are made on time, the principal of no harm no foul stands. After all, seasoned bankers won’t lend even hundred dollars in export loan if they weren’t sure that the sponsor had stuffed two hundred in an offshore account abroad.
But next time a Seth complains of lack of enabling environment that keeps his firm from expansion, ask if he also insists on keeping his several units operating under same line of business as private-limited. And then let the buyer (of malarkey!) beware.
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