December 30, 2002	Monday	Shawwal 25, 1423

Banking is one of the most sensitive businesses all over the world. Efficient banking is the basis of a viable economic structure and growth. Pakistan is no exception.

The country started without any worthwhile banking network in 1947 but witnessed phenomenal growth in the first two decades. By 1970, it had acquired a flourishing banking sector. The characteristics that distinguished it were that it was indigenous, growth oriented, and well integrated with the local business. Its intermediation cost was reasonable. Its assets were well secured and liabilities well protected. It enjoyed an image of reliability, integrity and support to the business community.

The first exception to the otherwise good reputation of the banking business was noticed when one of the small banks; namely the Standard Bank Ltd, started securing patronage of Army Generals for procuring business by using inappropriate methods. This was the beginning of institutional corruption at the highest bureaucratic levels.

The State Bank of Pakistan (SBP) was established with a banking control and inspection department but it had a limited role to play in regulating the banking business. The banking business, however, suffered no loss of image or substance because of its limited role. The reason being that the bank management was more pro-active to observe a self-imposed business ethics.

Nationalization of banks in the seventies changed the whole complexion of the banking industry in the country. With one stroke of pen, the commercial banks were made subservient to the political leadership and the bureaucracy. Specialized banking institutions were already working in the public sector. The new accountability paradigm changed the business ethics in the banking industry, and with this change started the disaster.

Nationalization of banking industry was accompanied by violent changes in the external value of rupee. The commercial banks thus lost their equilibrium, initiative and growth momentum. They ceased to be a business concern and became big bureaucracies. This was accompanied by indiscreet loaning under political pressure. They suffered from three terminal diseases: non-performing loans; higher intermediation cost; and loss of initiative and entrepreneurship.

In the meanwhile, western banks started entering into the business. They, with the support of ruling elite, concentrated on the big business, leaving the routine business to the local banks. This reduced the profitability of the local banks.The government permitted small private sector banks to operate, which indulged in questionable policies to promote business. The public sector banking, which constituted the backbone, thus continued to suffer because of their approach, size and carried over liabilities.

The biggest problem for the economic managers of the country was that they had no vision to resolve the structural incompetence of the public sector banking industry. Privatization was considered to be a solution, but neither the objectives nor the mechanism of privatization process were clearly spelled out. As a result, privatization process could not gain momentum even after unloading of two of the commercial banks; i.e. the Muslim Commercial Bank and the Allied Bank and a few DFIs.

The problems accentuated gradually as the issue of non-performing loans was politicized by one of the interim governments and soon thereafter, some of the newly established private banks and privatized DFIs started crumbling and the State Bank had to directly intervene to protect the depositors.

At this stage, the World Bank entered into the game by providing a credit for improving the financial sector. The prescription of the World Bank for improving the health of the financial sector was quite simple. The bank believed that privatization and globalization of the economic activity was the only solution to the problems of developing countries. It thus prescribed induction of imported leadership (or professionalization), transfer of non-performing loans to a specialized agency, effective regulation, introduction of e banking, rationalization of branches and the staff and finally the privatization by allowing international bidders.

The World Bank prescription is thus working to the desired ends. The public sector banks have a new leadership that has a background of working with multi-nationals. They have transferred a part of the non-performing loans to the new entity created for the purpose. The SBP is now regulating the commercial banks through what it calls the prudent regulations. The bank branches in major urban business areas are switching over to e banking thus minimizing the cultural difference between the domestic and foreign banks. A large number of unprofitable branches have been closed and the staff at the tail has been reduced. All of this has apparently given a new, attractive, state of the art look to the public sector banks. World Bank funding through the State Bank has helped improve their balance sheets and as a result United Bank has already been privatized and Habib Bank is not far behind the ultimate.

The reality on ground on the other hand is that banking efficiency has not improved despite all the initiatives taken by the SBP. This is evident by the high intermediation cost of the public sector banks. Why it is so? The reasons are obvious. Firstly, the steps taken by the banks under improved financial sector programme have not reduced their operational costs. The operational cost has in fact increased as the new leadership is trying to run the local banks on the pattern of foreign banks, without realizing that their business is much dispersed and the size of their average transaction is relatively small.

Secondly, their loan portfolios have not been effectively cleaned to provide them a fresh start. (the World Bank money has instead been used for golden handshake) And finally, the prudential regulations have reduced the management’s capability to use the available resources in an effective manner. The sum total of this situation is that all the commercial banks have enough liquidity but insignificant new advances; hence little domestic investment and resultantly a stagnant economy. Impact of this policy is a low rate of growth for the economy and a high intermediation cost for the domestic banks.

Public sector investment in the country has already receded as IFIs do not support any such initiative and are pressing hard for the privatization of most of the public assets. The growth in a developing country is thus dependent on private investment. Banks are a major vehicle to support the private investment both in formal and informal sectors of the economy. The need of the hour therefore is that the government provides a helping hand to the banking sector to play their role in economic growth more effectively.

Regulating the banks is important to protect depositors’ money but over-regulating them is dangerous and counter-productive. It is like killing the hen that gives the golden eggs. There is no doubt that a major factor in the poor performance of the banking sector in Pakistan was the absence of a regulatory framework but that was not the key factor. The autonomy allowed to the State Bank and the prudential regulations introduced by it have perhaps gone too far. The barking dog has become a biting dog. This has certainly curtailed the ingenuity and enterprising character of the domestic banking industry.

The new arrangements segregating the regulating functions of banks and NBFCs and placing them with SBP and SEC respectively are more pragmatic as NBFCs perhaps need more strict supervision whereas banks need only broad supervision and in turn more freedom to operate and take decisions. Shaukat Aziz is however right that prudential regulations need further review so that banking system takes complete ownership of risk management. Over-regulating the banks would not help. It would only cripple them.