BY choosing which endeavour to support, the financial sector directs a country’s savings into various activities. Hence, it effectively determines a country’s growth trajectory. Given such a key role, one cannot be faulted from expecting that policymakers and planners should pay special attention to it.

Astonishingly, it turns out that this appreciation of the role of the financial sector is entirely missing from the development narrative. And, we have paid a heavy price for it.

In the case of Pakistan, banks are the primary custodians of our nation’s savings. However, the lending contracts that they offer, are all very primitive.

The only contracts that banks can work with are debt contracts and its various extensions (buying government bonds) in which the lender expects to get a fixed payoff regardless of the success or the failure of the endeavour being financed.

Without having a stake in the upside potential, banks naturally and understandably try to minimise downside risk by attempting to choose borrowers who would not default and by requiring them to provide collateral. To a bank, there is no borrower safer than the government, as the government can always print more money to pay off its domestic debt.

No wonder, then, that the government is the single largest borrower from our banking sector. In fact, the most profitable bank — MCB — lends half of its money to the government. What is left after directing most of the country’s savings into an ever expanding government belly, goes to large-scale businesses, mostly for their operational needs.

Lending only to the government and to large businesses is a bad idea, even more so for economic development. Lending to the government has little chance of being productive, even when the government has the best of intentions. This is because the government, like any outsider, cannot substitute for local knowledge.

Nothing illustrates this more clearly than the failure of the much touted Millennium Village project started by Harvard economist Jeffrey Sachs. On behalf of the Ugandan government, and with funds raised from international donors, he intervened in the villages of southern Uganda.

In one village, growers who were barely farming enough maize just to survive were given fertiliser, high yield seeds, and training in modern farming methods. The result was an astounding increase in yield. The yield tripled in one season.

However, this bumper maize crop didn’t do anything for farmers, as there were no proper storage facilities to store the crop, which was eaten mostly by rats, vermin, and other pests. Consequently, farmers were back to barely subsistence living, with the added despair of having their dreams of a better life thoroughly shattered.

The lesson is that it is almost impossible for an outsider (government) to think through an intervention properly. No outsider or government can have that kind of complete local knowledge. So, even if the government has the best of intentions, it cannot take over the role of markets that embody such local knowledge.

If lending to the government does not do much for economic development, lending to large businesses perhaps does even little. The idea that let the rich get richer and that eventually the poor will benefit too has been as thoroughly refuted by enough evidence by now as an idea can ever be.

We have a society that collects its entire savings and gives it to large businesses, and hopes that such a policy will bring a rising tide that would lift all boats. Surely, there is a rising tide, but it only lifts luxury yachts, while ordinary boats just sink.

We desperately need an innovative financial sector that could respond to the needs of our society. We need a sector that supports the best ideas and not risk-averse ideas. Look around you. You could spot many people who have the necessary skills and the desired local knowledge to start small businesses. But, nobody is willing to fund them.

We are in a situation in which the custodians of the society’s resources are largely indifferent to the plight of the people. This is because the incentives of the custodians are not aligned with those of the society in general. The incentives are misaligned due to the debt contract.

If lending takes place through a profit-sharing or modaraba contract, then banks would have a direct stake in the success of the project. Risk vs reward will thus determine it, in contrast with just debts with the lowest risk.

There are some excellent examples in the microfinance sector such as Akhuwat, whose network and model can be scaled up for the purpose of modaraba contracts. One needs to experiment, start small, learn from mistakes, and improve.

Potentially, the needed institutional capacity for profit-loss sharing contracts could be developed this way.

The writer is a Research Fellow at the Risk and Sustainable Management Group, University of Queensland and Associate Professor of Economics at LUMS.

h.siddiqi@uq.edu.au