Fault lines in the banking system

Banking sector has failed to mobilise financial savings, improving efficiency in services, providing credit on merit.

The banking system had degenerated into a financial bureaucracy from a service industry, while the State Bank of Pakistan (SBP) was converted from a central bank into a de facto attached department of the ministry of finance following their nationalisation in the 1970s. Monetary policy became an extension of fiscal policy and banks began to be run like other government agencies under the administrative control of the Pakistan Banking Council (PBC). Amongst other things, banks’ capital base got eroded and the banking system was on the verge of collapse by the early 1990s.

Realising the gravity of the situation, major banking reforms were undertaken during the 1990s to rescue the system from collapse. Development finance institutions were gradually winded down. Banking laws were amended to eliminate political and bureaucratic interference in the banking system. Trade unions were brought under control through legislation and administrative measures. Initially, professional managements were installed in nationalised banks. Later on, those were privatised with the exception of the National Bank of Pakistan. Provincial banks were converted into scheduled banks and brought under the SBP jurisdiction and the PBC was abolished. The ministry of finance was legally barred from issuing any instruction to banks that were in conflict with the regulations and policies of the SBP. The SBP was given exclusive legal authority to regulate and supervise the banks on a professional basis and formulate and implement monetary policy independently. These were landmark reforms in the banking history of the country.

These expectations have not fully materialised in practice. The banking sector has improved in certain respects, and particularly its profitability has gone up sharply attracting domestic and foreign investment. The equity base of banks stands strengthened and the improper influence of trade unions stands curtailed. However, it has failed in mobilising financial savings, improving efficiency in banking services and providing credit on merit for productive purposes to all sectors of the economy so as to help the country move on a path of high growth with price stability. There are several fault lines in the actual functioning of the banking system that have stood in the way of realisation of all positive results from banking reforms.

First, the gap between banking practices and law has widened. The SBP has failed to convert its de jure autonomy into a de facto one. In practice, political influence has re-emerged both in the operations of banks and in the conduct of monetary policy.

Second, in the matter of credit, the government has begun to pre-empt the financial resources of banks to finance its unproductive expenditure to the detriment of the private sector, crowding out the private sector both in terms of the availability and cost of credit.

Third, the high lending rates have not been allowed to translate into higher deposit rates. The rising interest income of banks has been absorbed in increased profits of equity shareholders. The SBP, which as a central bank is required to protect the interests of depositors, has miserably failed to do so. In the process, there has been a substantial financial disintermediation in the country. Fourth, the commercial banks have failed to reduce malpractices in bank business, improve bank services, reduce administrative costs and limit loan defaults.

Fifth, the SBP has been unable to promote good governance in banks because it failed to create a firewall between ownership, policy formulation and operations in the banks. The result has been no improvement in the governance of the banking system. This is for several reasons. The government and the SBP did not take proper care to ensure that privatisation did not lead to interlocking of banks, other commercial business and industries and thereby minimise the conflict of interest in running the banks. The ownership, clientage, directorship and management of banks are all intermingled, leading to poor governance practices.

It is of utmost importance that the SBP corrects these fault lines in the governance of banks and of itself to ensure that the banking system and the SBP function in line with the revised legal framework and make their contribution to the promotion of financial saving, efficient allocation of resources and realisation of the growth potential of the country within the framework of sound banking practices and financial and price stability.

Published in The Express Tribune, November 27^th, 2011.