November 5, 2001	Monday	haba’an 18, 1422

A LARGE body of research and policy makers now link financial sector development, including the depth of the banking system, liquidity in capital market, and financial liberalisation to long-run growth and poverty reduction.

This view got further strength after witnessing the drastic effects of vulnerabilities of financial sector during the East Asian Crisis in 1997. The financial sector in Pakistan expanded manifold after 1980 and in the early nineties.

Unfortunately, for different reasons, this phenomenal growth could not be sustained and over the past few years, the country has been witnessing a series of bank failures and significant reduction in outreach of financial services. The situation has become extremely alarming as sources of long-term finance have almost dried up due to low level of savers’ interest in the banking system, lack of banks’ ability to undertake long- term risk in projects, and most importantly, weaknesses in the legal and institutional infrastructure that supports development of a healthy financial sector.

The development financing institutions (DFIs) that were created for this purpose are being closed down as these were grossly misused by corrupt political elite to divert resources towards their crony allies. The key question is that in the absence of a financial system that has the capacity to rationally allocate resources to productive projects, is it realistic to expect industry-led economic growth in the near future, in Pakistan? This article explains the basic functions of the modern financial architecture and its link to long-term growth.

In a historical perspective, it is argued that industrialisation in France under Napoleon III was speeded up by the creation of a credit system that provided long-term funds for large-scale projects. German industrialisation in the late 19th century was also accelerated by the active intervention of its banks that did not only provide required financial resources but also helped to overcome scarcity of managerial skills among the entrepreneurs.

In a similar manner, England’s 18th century industrialisation could actually have happened earlier, had the financial system been sufficiently developed to support the technological advancements. England had to develop capital market to access the long-term capital resources. While acknowledging the key link between financial sector development and growth, it is, however, very interesting to note that banks in developed countries became professional lending institutions only in the early 20th century.

Before then, personal connections strongly influenced bank-lending decisions. For example, throughout the 19th century, the US banks lent the bulk of money to their directors, their relatives, and those they knew. Even in earlier 20th century, the US banking system comprised of thousands of small weakly managed and supervised institutions. The examples of bank failure were common and it was only in the recent past that sophisticated institutional framework was created that helped resource mobilisation and allocation of credit though the financial markets.

It is an important lesson for developing countries that growth of advanced financial systems has a history of hundreds of years’ volatility in the financial markets. Capital market development followed the banking system and it is interesting to note that even today, equity market consists of only 5 per cent of overall financing in the United States. It is really hard to replicate a successful model in a developing perspective without putting the supporting infrastructure right.

A well-functioning financial system raises the welfare of households by providing them the opportunity to borrow and lend for smooth consumption. First, the financial system mobilises savings from a pool of individual investors and make these savings available for onward lending. In the absence of a financial system, individual investors might not want to or not be able to finance a viable project. Firms seeking funds greatly reduce transaction cost by going to one financial institution and avoiding reaching several scattered investors. It is true for savers, as they do not have the individual capacity to identify and invest in feasible ventures.

Due to their technical superiority, financial institutions allocate resources to productive projects. It is obvious that financial institutions develop a capacity to evaluate risks associated with project financing. This role can also be described as transforming risk by passing it on to those who are willing to bear it. The risk is also reduced through diversification and insurance. If investors manage to diversify, only systemic risk could pose a threat and productive ventures with higher idiosyncratic risk can be undertaken. The risk reduction creates incentives for savings in an economic system.

Another important function of the financial system is to generate liquidity for both short and long term financing needs of the firms. The nature of commercial ventures is quite dynamic and so are their financial requirements. To match the exact needs of financing in terms of volume of money and period of lending, financial institutions develop a range of products for savers. This also provides flexibility to different kinds of savers who may have different preferences for savings.

Financial system also facilitates trade by offering a range of credit instruments like over-drafts, credit cards, electronic payment systems, and guarantees. This speeds up the exchange of goods and services, both in local as well as international markets. In addition to that, financial institutions play a major role of transferring skills to entrepreneurs. The partnership between the firm and the financial institutions expertise for the maximum benefit of the business venture. Financial institutions, as lenders, continuously monitor the operations of projects and also come up with the bailout strategies, if needed. This function is important to safeguard the interests of small investors as it minimises the possibility of moral hazards by wrong reporting of financial figures by the managers of the firms.

Due to the features discussed above, it can be established that a well-functioning financial system significantly contributes towards economic growth. The society attains optimal level of savings and investment and capital moves towards the projects with highest expected risk-adjusted rates of return. A good financial system also provides low-cost means to make payments. Technological advancements and industrialisation have been the major engine of economic growth in the developed countries (except oil producing countries). In the absence of efficient financial markets, investment projects become too costly for individual investors or firms from a financing point of view. Financial intermediaries do not only maximise households’ investment by cutting down the transaction cost but also, at the same time, provide useful managerial and technical input to the entrepreneurs.

It is generally agreed that well functioning banks spur technological innovation by identifying and funding those entrepreneurs with the best chances of successfully implementing innovative products and production processes. The potential benefits of economic growth for improving human welfare need not be over-emphasised. For example, Bangladesh, India, and Pakistan, three of the world’s lowest income nations, have real per capita GDP between $1,500-$2,000.

In contrast, the equivalent values for three of the world’s highest income nations, Denmark, Sweden, and the United States are in the range of $18,000-$25,000. As one can see the difference is more than ten times and it is obvious that the people in rich countries can enjoy better quality of health and education. Social scientists, particularly the development practitioners, hold quite different views about the relationship between economic growth and development. Many development thinkers argue that pure economic growth does not redistribute wealth in equitable proportion and policy has to aim for right mechanisms for redistribution of income. However, the experience of economic growth in East Asia significantly reduced poverty and the financial crisis hit the poor more than any one else.

Financial systems mainly exist to facilitate the allocation of resources across space and time, in an environment of uncertainty and transaction cost. In a developed financial system, savers’ money is efficiently channelled to productive investments, whereas, an imperfect financial market excludes several profitable avenues of investment.

According to Stiglitz, the former Chief Economist of the World Bank, successful development requires not only the agglomeration of capital but also appropriate allocation and management of capital. Financial institutions’ role of screening and monitoring becomes very critical in this scenario.

In the context of Pakistan, we do not only need long term bank financing and managerial capabilities for large industrial projects but also need an efficient equities market that can provide risk capital to innovative technological ventures.

This cannot be achieved without strengthening supporting institutional structure that provides comfort to investors for placing their investments in the financial system.

The policy has to aim for less state intervention, smart handling of bank failures, strong regulatory framework, and functional legal system to ensure compliance of financial contracts.