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Rules for Banks and DFIs: brokerage subsidiaries be kept at arms length

KARACHI (February 11 2004): The State Bank on Tuesday emphasised the need to ensure that the relationship between a bank or DFI and its brokerage subsidiary is on an arms length basis, and foolproof firewalls have been built to avoid conflict of interest.

The SBP has issued a detailed circular with a number of instructions and guidelines for banks and DFIs who carry on business of brokerage houses as subsidiary.

The sale and purchase of shares and securities conducted through the subsidiary, in the first year of operations of the subsidiary, should not exceed 50 percent of the trading undertaken by the bank/DFI.

In subsequent years, the trading through their own subsidiary should not exceed 25 percent of the total trading conducted by the bank/DFI.

For the purpose of this regulation, the shares and securities will be valued at market rates, the circular said.

The circular stated that while State Bank of Pakistan encourages banks/DFIs to diversify their activities, bring innovative financial products to the market, broaden the product offerings, etc, it wants banks/DFIs to develop and put in place effective internal controls, checks and balances to ensure that activities are conducted in a prudent manner.

The banks/DFIs will be allowed to conduct brokerage business through their separately set up subsidiaries for this activity. It, however, needs to be ensured that the relationship between the bank/DFI and its brokerage subsidiary is on an arms length basis and foolproof firewalls are built to avoid conflict of interest and to restrict the banks/ DFIs' responsibilities and liabilities vis–vis their brokerage subsidiaries.

In this backdrop, following regulations have been issued by the State Bank for banks/DFIs intending to undertake brokerage business through subsidiaries:

The banks/DFIs desirous of undertaking brokerage business shall obtain prior approval from State Bank of Pakistan. While applying to State Bank of Pakistan for approval, besides the other information that State Bank may require, the bank/DFI shall submit the complete feasibility study, the amount of investment to be made by the bank/DFI in the paid-up capital of the subsidiary and the structure of both the proposed Board of Directors (including the names of the directors to be nominated by the bank/DFI) and management.

The brokerage business shall be conducted through a separate subsidiary, which will be a limited company. The bank/DFI will ensure that the subsidiary works as a completely independent and distinct entity.

In order to allow the subsidiary to take benefit of the brand name, the brand name of the bank/DFI is allowed to be used in the name of subsidiary. However, it shall be ensured that the word 'Bank' is not used in any manner in the name of the subsidiary.

Before commencement of business by the subsidiary, the bank/DFI will prepare written procedures for creating/building firewalls between the bank/DFI and the subsidiary. It will be ensured that the relationship is not used to access the confidential information of the customers/clients of the bank/DFI.

Bank's/DFI's customers may, however, deposit money in the bank/DFI to be used as margin against trading through the subsidiary.

The banks/DFIs shall obtain prior approval of State Bank of Pakistan, before increasing their investment in the equity of the subsidiary.

The management of the subsidiary will be completely different from the management of the bank/DFI. No person will be allowed to hold positions simultaneously in the bank/DFI and in the subsidiary. Employees will not be transferred from the subsidiary to the bank/DFI or vice versa.

The bank/DFI may, however, send its employees on deputation to the subsidiary. The bank/DFI may also provide support functions / services like human resource, administration, accounting, information technology and other secretarial & general services for the subsidiary and share costs of overheads and fixed assets on predetermined terms and conditions.

Board of Directors of the subsidiary will be completely independent and different from the Board of Directors of the bank/DFI. The bank/DFI may nominate its employees on the Board of Directors of the subsidiary up to 40 percent of the total directors nominated by the bank/DFI, and the remaining directors nominated by the bank/DFI should be independent individuals.

In case the members of the Board of Directors of the bank/DFI and their family members or employees of the bank/DFI and their family members wish to conduct sale and purchase of shares or securities or any other trading through the subsidiary, they will disclose all the transactions conducted through the subsidiary to the bank/DFI by submitting periodical statements on regular basis. The format of such reports and their periodicity may be determined by the bank/DFI themselves.

The subsidiary will not undertake, either on its own or on behalf of its clients, sale and purchase of the shares of the bank/DFI or securities issued by the bank/DFI.

While it is expected that banks/DFIs would have instituted effective checks and balances and internal controls in their dealing rooms, deals conducted through their subsidiary should be monitored more closely.

All deals of the bank/DFI conducted through the subsidiary must be made from designated fixed telephone lines installed in the dealing room and connected to a voice recording system.

All trades of the bank/DFI executed through the subsidiary during the day, for which contracts and bills are received, must be matched with recorded conversations as well as all verbal orders given during the day, that have been taped, must be backed by contracts/bills at the end of the day to ensure that all deals have been properly taken into account.

The bank/DFI may utilise their distribution channels for selling the products of the subsidiary. However, for this purpose, the bank/DFI will execute written agreement with the subsidiary. The agreement should inter alia lay down the sales terms and conditions, features of the products to be sold by the bank/DFI on behalf of the subsidiary and fees to be charged by the bank/DFI for this purpose.

The bank/DFI will take appropriate measures to disclose to the buyers of such products that they are buying the products of the subsidiary and not that of the bank/DFI and the bank/DFI is not guaranteeing or undertaking the repayment of any sort.

The banks/DFIs should also ensure that the products offered by the subsidiary and distributed / sold by them do not resemble the products of the bank/DFI.

The subsidiary may share the systems or other infrastructure of the bank/DFI as allowed under Regulation 6 of this circular.

The premises of the bank/DFI may be utilised by the subsidiary, on an arms length basis and subject to the condition that both the bank/DFI and its subsidiary are made clearly and prominently identifiable through separate entrances, display of boards and other means.

The banks/DFIs shall ensure that all the sale or support services performed by them or premises provided by them to the subsidiaries are on arms length and on commercial basis and appropriate fees are charged for these services.

The bank/DFI will ensure that it is not assuming any sort of legal liability on behalf of its subsidiaries and its products. For this purpose, besides taking other necessary measures, the bank/DFI will also obtain professional legal opinion.

The bank/DFI will not provide any non-fund based facility to the subsidiary. However, fund based facilities and margin financing may be provided by the bank/DFI to its subsidiaries under the relevant regulations of SBP and subject to the observance of Per Party Exposure Limit for fund-based exposure under Prudential Regulation R-1.

In case it is found during the inspection or through other sources that the relationship (parent & subsidiary) has been used to structure a transaction or transactions to defeat the purposes of SBP regulations or banking laws, State Bank of Pakistan may, at its own discretion, direct the delinquent bank/DFI to dispose of/transfer its equity holding in the subsidiary within such time and in such manner as prescribed by State Bank and may also make a simultaneous request to SECP for the cancellation of the licence of the subsidiary.

This measure shall be without prejudice to any other action which State Bank may take in this respect.

State Bank of Pakistan will closely monitor the situation on continuous basis and, if needed, the regulations may be modified from time to time.

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