Delivering his annual address at the Institute of Bankers Pakistan on Wednesday, Governor State Bank Syed Salim Raza raised the question whether smaller institutions in the financial sector are necessarily safer? It seems that Governor Raza strongly feels that the funding model and the extent of leverage of an institution is more important than its size.
According to him, it was not the size of Lehman Brothers but its interconnectedness with the rest of the financial system which turned its failure into a problem. Large banks in West were interconnected due to their heavy dependence on wholesale funding.
Unlike the developed world, large banks in Pakistan are overly dependent on the government and public sector entities for both deposits as well as advances. They also compete with government's NSS schemes, hogging or taking more than their share of household and corporate savings. A snapshot of their dependence was seen last year when the government attempted to suddenly pull out Rs 40 billion from the system to reduce its borrowing from the central bank. There are around Rs 750 billion plus government sector funds lying with the banks.
Due to the circular debt emanating from oil, gas and power sector government entities and constant haemorrhage of the budget - there is a growing reliance of the government to use the banking system to overcome its own budgetary constraints. During the course of the year, private sector advances have significantly dwindled while government borrowing from banks has soared. The government guaranteed debt is either rolled over or turned from advance into investment.
Governor Raza plans to talk to individual Board of Directors of institutions to have a well-thought out business plan with proper capital and liquidity buffers to hedge against the risk they pose. Their organisation structure should enable an orderly winding down. This is termed a living will. A living will is a document that states how we wish to be treated, if we become incapacitated by injury, illness, or old age. In this case, however, institutions in advance for their orderly death provide an effective separation in a crisis.
SBP's minimum capital requirement (MCR) seeks to help create larger and more resilient institutions. However, the roadmap provided by Governor Raza's predecessor has been revised and banks were provided with a breather mainly due to economic slowdown. Banks are now required to accumulate capital of Rs 10 billion by 2013. It is rather difficult for those banks having less than Rs 10 billion capital, at present, to compete. Therefore, the situation has warranted mergers and acquisitions. SBP needs to push large banks to step up to the plate for this. Some may come up with a plausible argument that such a strategy would lead to reduce fair and healthy competition in the field.
The real challenge for the regulators is to separate deposit taking and payment system from more speculative ventures such as propriety trading and other risky parts of banking. At present, SBP has allowed asset management and modarabas as subsidiaries. Leasing is permissible for commercial banks. Due to a lack of opportunities - investment banks have obtained commercial bank licences. We do not have development finance institutions which can act as an appropriate and useful vehicle for large infrastructure projects. Even public-private partnerships envisaged for such ventures are struggling to see the light of day.
The condition of other non-bank sector financial institutions is indeed worrisome. The model for development finance institutions or investment banks is tenuous in present conditions. A tax structure armed with effective leasing instruments and tools - so crucial for small and medium-sized businesses - is woefully absent. Loans provided to agriculture sector are not commensurate with the rural deposits. Banks as well as non-banks have yet to create a dent in the clutches of private money-lenders, who are squeezing small farmers.
Therefore, the challenges faced by our policymakers and financial supervisors are not only numerous but also quite different from those in the West. Here the issue, among others, relates to family-controlled dominance within an institution. Combining the financial and industrial strength to virtually strangle competition as well as raising the bar for new entrants are other serious matters of concern in this regard.
An environment promising or envisaging an arm's length financial transactions and having a Chinese wall between ownership and management is at best profoundly weak or just non-existent. The regulators abroad are involved in dismantling the shape of the past in the financial world with a view to avoiding a future crisis. In Pakistan, we need to create a shape for the future to overcome our past which has bogged us down.