A banking crisis may not happen in Pakistan any time soon but it would be prudent to get ready to handle it if it does occur.

When I raised the possibility that something like that could happen a couple of years ago I was told that the banking system was healthy.

This conversation took place when the former Governor of the State Bank of Pakistan visited Washington and addressed the Woodrow Wilson Center for International Scholars. I was told that the regulators working in the State Bank were watching the banking system carefully. My worry then had much to do with my experience handling financial crises in Latin America when I was in charge of the region at the World Bank.

I had been promoted to Vice President of Latin America after having worked as Director of the World Bank’s China programme for several years. I saw how the Chinese were managing their financial system. While they had allowed the private sector to expand rapidly in the real sectors of the economy – in agriculture and manufacturing – they had resisted calls for admitting in any big way private entrepreneurship into the banking sector.

By maintaining government’s control over much of the banking sector, they were able to direct credit into the real sectors and into the activities the state regarded as having a high priority. The government owned banks did not, therefore, compete with one another to gain share in the market.

The Latin American countries had followed a different approach. The structure of their banking system was modeled after the one that had developed in the United States where commercial and investment banking was entirely in the hands of the private sector. The government’s role was limited to supervising and regulating one part of the banking sector, the part that was allowed to receive deposits from private savers.

The American banking system was made up of tens of thousands of banks, large and small, that competed aggressively with one another for both deposits and for making loans. This competition had resulted in a great deal of innovation.

Developing countries were advised by the Washington based development and finance institutions to adopt the American model. Pakistan was one of the several countries that had taken that advice and with the help of a privatisation programme transferred much of the banking

sector to private hands.

The privatised banks worked hard to penetrate the market for both deposits and loans. Consumer finance became an important part of their business. This had also happened in many Latin American countries, in particular in Argentina, Brazil and Mexico and all of them had severe banking crises.

I was called upon to help these countries work their way out of the crises. Could something like that happen in Pakistan, I worried then when the former Governor came to the Woodrow Wilson Center. I worry once again as many large financial centres in the world are in the grip of banking crises that were not anticipated.

At the moment, Pakistan is handling several very difficult economic problems. Trouble in the banking system would be the last straw on the back of an already loaded camel. To be ready were something like that to happen would be a wise thing to do. Why do I believe that there is some danger that the country’s banking system may be heading towards difficulties?

There are three reasons for my worry at this time. The first relates to the structure of the banking system in the country. As already indicated, Pakistan has followed the American model in restructuring banking. Over the last several years, several new entrepreneurs have entered the banking system and significant amount of private capital has come in from abroad. This has produced competition and with competition have come practices that are not sound for the long-term health of the system.

Two, having gone aggressively into consumer finance in the last several years, Pakistani banks are exposed to the kind of risks that have brought down the American banking system.

As is well known, the American banks ran into problems for two reasons. They lent to home owners for purchasing properties they could not afford. This is what the Americans call “subprime” lending. Having done that, the American banks repackaged the loans they had provided into complex products and sold them to the investors that had the appetite for long-term investments.

How could the products based on risky assets receive AAA rating from credit agencies? This is where mathematics entered the picture. Those who modeled the products were able to stack the underlying assets in such a way that those at the top tier would not get hurt if there were defaults on those at the bottom. Losses were captured in the bottom tiers of the composite products; they were not meant to float to the top. In theory this seemed reasonable; in practice, this proved to be problematic.

The third worry is something that normally escapes the notice of most policy makers. Even in well run banking systems that operate in a highly competitive environment – which may be the case in Pakistan – economic downturn produce additional strains.

The first impact of economic slow down is felt in investment; the proportion of gross domestic product that goes into investment falls before that committed to consumption.

This means that banks find that they have to lend more for consumption than would be the case in a normal economic situation. It is only when there are significant increases in the rate of unemployment among the relatively more well-to-do segments of the society that people reduce bank borrowing for consumption.

Since there has been a significant slowdown in economic activity, the banks will begin to show an even greater exposure to consumer finance. How should the Pakistani authorities prepare themselves? At this point, the bank regulating and supervising agencies should carefully review the risk profile of the banks and grade them according to their exposures, giving a much higher weight to the assets that are potentially at greater risk. They should ask the banks with higher risk profiles to set aside larger amounts of capital if they run into trouble. It is much better to anticipate the problem than act when it has already occurred.

The World Bank learned from the crises it handled in Latin America and later in East Asia that once weaknesses appear, the cost for dealing with them increases very rapidly. This lesson is being taught to the American policy makers once again.

I recall a conversation I had with the minister of finance in late 1994 as his country was in a full-fledged banking crisis. I asked him what would be the cost to the economy of dealing with the problem by recapitalising the affected banks. He thought the cost would be about five per cent. I told him that my estimate was around 20 per cent.

He asked me why I was much more pessimistic. Was my estimate based on some careful analysis done at the World Bank. I said it wasn’t; what experience had taught me was to multiply by four what the finance people offered as their estimate for handling financial crises. The point of recalling this conversation is to emphasise that financial crises invariably take a heavy economic toll. It is prudent to prepare for them well in advance.