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June 24, 2017

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Banks and the public purpose in Pakistan's stagnant economy

ISLAMABAD -- High deficits, inflation and shrinking investment attenuate the capacity for policy intervention to raise Pakistan's economy from stagnation. How then can countercyclical action be undertaken, of the size and sustainability required?

Assuming government takes up due policy reform, Pakistan's banking sector, overall profitable and well capitalized, can help lead the countercyclical thrust. However, banks were only narrowly engaged with the larger economy; and now are fast transferring from private to government lending. Nor is there specialized capability for infrastructure and development necessary to stimulate domestic investment.

What must be done to engage banks more substantially with the economy, and to endow the sector with skills to sustain long-term development? Let's first identify the universal role of banks' public purpose.

The public mandate to banks is to harness national savings and apply them to economic ends; and to manage the national payments mechanism. Because banks have high leverage, the state provides lender of last resort support and partial deposit insurance. Shareholders contribute less than 10 percent of the banks' resources (the capital ratio); business earnings arise predominantly from public deposits.

Given networked interests, the banking industry is a kind of public-private partnership (PPP) — a collaborative exercise, based on mutual trust. Managing this trust is delicate business.

Moral hazard exists. Depositors' returns can be suppressed in favor of higher returns to management and shareholders; high risk-high reward profits can be generated from speculative, rather than economic, activity. Market "failure" is a risk.

Banks may not allocate credit for the most favorable long-term outcomes, but to what favors their shareholders now — and not face the countervailing challenge, given the oligopolistic power that can exist within financial systems. The self-perception of dominant banks as "too big to fail" and "too big to be pushed around" also creates moral hazard.

The current global financial crisis erupted out of moral hazard and market failure. The "free-market" euphoria took banks beyond the bounds of the public mandate, imposing punishing costs on society.

In emerging markets (EMs), the role of the banking sector is to spur development, i.e., stimulate economic growth, deepen financial markets and hasten financial inclusion. The state in many EMs owns majority stakes in commercial banks and development institutions (DFIs), financing infrastructure, power, agriculture, etc.

In the rapid, post-globalization growth of EMs, state-owned banks (SBs) — historically, considered inefficient — have performed effectively against goals for development and financial inclusion, where private banks would not lead. SBs have also limited slowdowns by increasing lending through economic downturns, i.e. countercyclical action.

Government ownership of banks in BRICs is nearly 90 percent in China, 70 percent in India, and in Russia and Brazil about 45 percent. But there's no "lock" on market share. Private and foreign banks are encouraged, and competition raises competence in the SBs.

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