ON September 1, the State Bank of Pakistan, through an advertisement, cautioned people interested in buying third party products from banks and development finance institutions. Products of other entities that are sold by banks in their capacity as distributors are known as third party products.

Generally, they include all types of insurance and investment products, except government securities like T-bills, Pakistan Investment Bonds (PIBs) and other securities issued by state enterprises. This activity has surfaced in recent years, prompting the SBP to issue guidelines to banks regarding this in June 2011.

It seems that the caution has been issued on receipt of a large number of complaints and grievances from banks’ clients who had purchased these products from them.

Commercial banks’ incomes come from fund-based and non-fund-based activities. The former comprises dealing in their own products, like advances, investments and bills purchased/discounted, which are backed by their deposit base and shown on their balance sheets. The latter are mostly off-balance sheet items like fees and commissions earned by issuance of guarantees, undertakings and selling third party products etc.

In the context of the sub-prime mortgage crisis of 2007-8, it was ironically said “the horse of financial innovation was much ahead of the mule of supervision”

Selling products of other parties is common in financial institutions in advanced economies, which have highly developed financial infrastructures. Non-bank financial institutions like investment banks, hedge funds etc are known for this because they are not supervised as heavily as commercial banks.

Being independent of the deposit base and not having to be shown on bank balance sheets, these apparently harmless activities sometimes become problematic during a crisis, or themselves become the main reason for the crisis.

That is why after the Great Depression of the 1930s, US commercial banks were barred from using their depositors’ money to invest in stock market and other securities under the Glass Steagall Act of 1933. In 1999, this border line was withdrawn under the Financial Services Modernisation Act, which opened the floodgates of financial innovation in the shape of non-fund-based activities and products, like asset-based securitisation, credit default swaps and collateralised debt obligations.

This made the working of banks highly complicated and largely unsupervisable even for central banks. In the context of the sub-prime mortgage crisis of 2007-8, it was ironically said that “the horse of financial innovation was much ahead of the mule of supervision”.

Now, the concept of ‘narrow banking’ is a hot topic in Western finance, as it will limit the role of banks largely to fund-based activities only. The so-called Volcker Rule, part of the Dodd- Frank Act of 2010 — passed after the crisis of 2008 — has restricted banks’ propriety trading of other financial instruments with its own money.

In Pakistan, the current conduct of the banking business has drastically changed with regards to the total neglect of the credit requirements of primary producing sectors of the economy. Under fund-based activities, sums of money invested in T-bills and PIBs are far more than the amount being lent to the private sector.

The younger generation of bankers — mostly equipped with western finance’s money-making techniques — is ever busy in selling third party products. Currently, both Islamic and interest-based banks are actively engaged in selling insurance policy packages to their clients. Islamic banks are restricted to Takafal companies (Islamic insurance), whereas conventional banks are working for both Islamic and conventional insurance companies.

Bank staffers are provided incentives for this business in the shape of foreign trips and fat bonuses. Users of such banking services are mostly low- and middle-income groups who want to save for the future. Since banks have a large client base, such activities are likely to increase in the future. In contrast, the Reserve Bank of India has discouraged banks from selling third party products.

It seems that the SBP’s warning is not likely to work effectively due to high financial illiteracy in the country, where the sanctioning of a loan by a bank manager is considered a favour. Around five to six years ago, banks had suffered a great deal of reputational and financial loss in cases involving car lease financing and consumer loans. For, how would customers resist the motivational pressure for purchasing an insurance policy after the sanctioning of a loan?

Furthermore, this new trend will not encourage banks to increase their financial outreach to agriculture and small and medium enterprises (SMEs). Against the annual agricultural credit requirement of more than one trillion rupees, banks are catering to only one-third of that, leaving farmers at the mercy of informal finance sources.

The SBP may like to revisit its policy on the subject. Banks may either be barred from this emerging activity or their exposure to it may be linked with their financial outreach to agriculture, SMEs and microfinance. Under its five-year strategic plan, the central bank promised to bring an additional 2m farmers and 3m SMEs into the banking fold.

The writer is the President of the Institute of Banking and Business Learning, Lahore.

munir1951@hotmail.com