Bigger is not always better

State Bank Governor Dr Ishrat Husain is famous for his candid views on monetary policy issues. Addressing a conference on "monetary and exchange rate regime" on 14th November, he underlined the fact that monetary policy in both advanced and developing countries cannot be formulated and implemented in isolation from government policies, no matter how much independent the central bank is in terms of its legal status.
This aspect was of utmost importance for developing countries that had a relatively weak taxation regime, with lingering suspicion of fiscal dominance hovering most of the time. In Pakistan, the government does not have a broad revenue base and domestic financial market does not have enough depth to absorb placements of public debt.
Therefore, though the precondition of independence of central bank is met for inflation targeting, other conditions are missing. Also, with the role of market forces expanding owning to liberalisation, deregulation and privatisation of the financial sector, there were changes taking place in the transmission mechanism of monetary policy.
Discussing the exchange rate regime in Pakistan, the Governor said that the current framework of monetary-cum-exchange rate policies and underlying economic analysis in Pakistan could be broadly characterised on judgement and discretion rather than model or rule based. He also pointed out that managed float had served the country quite well as it had conferred a degree of certainty and predictability to the exchange rate.
Talking to the media after delivering his speech, the Governor repeated once again his favourite thesis of limiting the number of financial institutions to only bigger banks. In this connection, the State Bank was going to increase the paid-up capital of the commercial banks to streamline the banking services and discard quantity in favour of quality. There was a significant gap between banks that really matter and those that were just there. The Governor said that of the 38 banks, 20 were generating 95 percent business while the remaining were confined to a mere 5 percent business. The colossal gap was a matter of concern to the central bank and it was decided that only 20 best performing banks would be allowed to operate.
The Governor's observations about the conduct of the monetary policy, in our view, are largely correct. No central bank can work in isolation and it has to take into account developments in other areas of the economy, particularly the fiscal outcome at a given point of time. Whatever the level of autonomy of the central bank under the Act, it has to operate under certain constraints.
It is precisely for this reason that there is a provision for Monetary and Fiscal Policies Co-ordination Board under the revised Act of the State Bank which is meant to co-ordinate fiscal, monetary and exchange rate policies and ensure consistency among macro-economic targets of growth, inflation and external accounts.
Having said this, it also needs to be understood that the main function of the central bank is ensuring monetary stability and it cannot take the cover of having to work in tandem with other organs of the state or inadequate independence for its inept policies. Sadly, the level of inflation in Pakistan in the recent past has raised certain questions about the degree of seriousness in the State Bank to play its part.
The observations that monetary and exchange rate policies are mostly judgmental is true because the economy is still undergoing a fundamental structural transformation and empirical links between various parameters are not very strong and reliable.
The Governor's views about the superiority of bigger banks are, however, hard to defend. During his tenure, he has been increasing paid-up capital prescribed for commercial banks to achieve this goal. In our view, efficiency and soundness of a financial institution should be given more importance than its size. In certain countries, unit banking is working perfectly well and serving the needs of the economy adequately. There should be no reason for worry if the regulatory and supervisory system of the central bank is immaculate and transparent to weed out weak financial institutions in time.
In fact, smaller banks can provide more personalised service, promote competition and create a niche to serve particular sectors and regions. Even if they fail sometimes, their impact on the economy will be limited. On the other hand, the failure of a bigger institution could create chaos in the whole economy.
We are worried about the present policy of the State Bank because some of the reputed foreign banks facilitating foreign trade and flow of funds from abroad have already been closed, while the remaining ones are not very happy about the present policy of raising paid-up capital very frequently. Hopefully, the next Governor of the State Bank would consider this matter in totality while designing a strategy about the size and paid-up capital of the banks instead of focusing on a particular aspect of banking.