More powers for the SBP

It is not often that a good piece of legislation faces such little resistance in parliament. But the new banking regulations have been passed unanimously in both the Senate and the National Assembly. The bill will dramatically expand the powers of the State Bank of Pakistan to deal with financial crises, including taking over banks and replacing their managements and writing down and imposing losses on debt and equity shareholders alike.

Given the fact that the top five banks in the country control up to 80 per cent of all deposits, Pakistan’s financial sector has a very serious ‘too big to fail’ problem. If one of the major commercial banks runs into trouble, the government has absolutely no choice but to bail it out, owing to the systemic risk a bankruptcy would pose to the health of the financial system. The management of these banks, of course, knows this and thus has an incentive to take excessive risks in order to increase their banks’ profitability, a problem of bad incentives known to economists as ‘moral hazard’.

The amendments to the Banking Companies Ordinance would address this problem. If bank managers know that they can lose their jobs in the event of a crisis at their bank, they are likely to be more prudent in taking risks. If investors in stocks and bonds of banks know that they could lose their money in the event of a bankruptcy, they are likely to urge the bank’s management to be more cautious. Moral hazard and the threat of a systemic risk to the banking network, in other words, stands ameliorated with the introduction of this law.

Given the fact that at least 13 banks are in violation of the central bank’s minimum capitalisation requirements, a banking crisis is likely. Giving the central bank more tools to confront the problem before a problem arises seems like a good idea and one that we can fully support.

Published in The Express Tribune, February 28^th, 2011.