KARACHI, Sept 11: The banking sector reforms initiated in 1997 have created a healthier primarily private-owned system but have exposed the bank deposits to risks with no insurance cover.

Deposits in the nationalized commercial banks and specialized institutions in public sector are guaranteed by the government. But this protective umbrella is not extended to privatized banks.

In early 1990s, ninety per cent of the system's assets were held by state-owned banks. Private commercial banks now control over 75 per cent of the assets. The government guarantee covers the National Bank of Pakistan and the specialized institutions.

In the past, a bankrupt National Development Finance Corporation and even a privately owned Mehran Bank were merged with the National Bank to compensate the depositors. The privatized Bankers Equity was liquidated but the interests of depositors were protected by the State Bank. Indus, a small private bank was liquidated with no compensation to the depositors.

To strengthen their financial viability, some weak banks were merged with the stronger ones under the State Bank policy of fewer but stronger banks. The capital requirement of banks is being gradually raised. They are being encouraged to move towards universal banking and diversify their sources of incomes. National Bank President Ali Raza says he is working for a ratio of 50:50 for interest and non-interest incomes.

But despite much healthier banks, the deposits are not hundred per cent safe. Finance capital is fragile and banking is a very risky business. It is struggle for survival of the fittest amidst severe competition. And there are economic booms and busts. There are bad times and good times.

To protect small savings and financial viability of the banks, the State Bank proposes to set up initially a Deposit Insurance Fund which is to be managed by the central bank with mandatory participation of all banks.

Under the proposal, access to the Fund will help protect deposits up to Rs100,000 equivalent to 3.8 times per capita GDP and covering 94 per cent of all accounts up to this amount and 52 per cent of the value of deposits. Envisaged is a flat profit premium of O.2 per cent of the total insurable deposits to be paid by the covered institutions and a seed funding of Rs5 billion by the government.

An important issue is as to who will share the insurance costs of the deposits. Given the present banking culture, it would be depositors who are likely to be made to pay for the protection money.

But IMF is worried on another count. It views the deposit insurance as a double-edged weapon. The scheme could help curb the tendency of depositors to flee at the first signs of trouble at an institution but it also risks reducing the discipline of the insured institution, encouraging more risk taking. The two aspects need to be balanced in the design of deposit insurance scheme.

Imprudent lending by the banks is a serious concern of the IMF. The Fund has been criticized by its largest shareholder, USA, for bailing out commercial banks that were hit by imprudent lending, through $100 billion loan to East Asian States in the aftermath of 1997/1998 fiscal crises.

In the opinion of the IMF, the deposit insurance agency should be run independently, free from political interference; the premium structure and coverage should ensure appropriate incentives and financial viability; and membership should be compulsory to prevent adverse selection and insolvent institutions should not be included.

Recommending that the State Bank's proposal should be considered further, the IMF notes that the setting up of the Deposit Insurance Fund could potentially create a conflict of interest between the SBP's role as lender of the last resort and as manager of the insurance fund.

The proposed coverage seems generous, while the level of proposed premium is influenced heavily by the impact of banks' profitability and appears to be low by international standards. And the proposed seed funding, at half the required amount estimated by the State Bank, needs to be considered in the context of the limited fiscal space of the government. There is also potential for an expansion of the scope of the scheme, says the IMF.