IN aggregate terms, Pakistan has a strong, stable and well-capitalised banking sector. The benchmark indicator of the health of the banking system, regulatory capital to risk-weighted assets, stood at nearly 15pc as of end-March 2014.

More importantly, barring four relatively small banks, all banks in Pakistan met the regulatory capital requirements. In a positive development, at least three of these banks are reported to have met the State Bank of Pakistan’s laid-down capital requirement in recent days.

Nonetheless, after years of well-managed stability, depositors suddenly woke up one morning a few weeks ago to read about a six-month ‘moratorium’ imposed by the government on a small-sized bank. This draconian move has been widely criticised as unnecessary and ill-conceived. The recent episode involving KASB bank was more a failure of SBP than of the concerned bank’s balance sheet. If SBP’s handling of KASB bank had been more professional, timely and discreet, stakeholders — especially depositors — would have remained convinced about the adequate capitalisation and stability of the financial system. The ham-handed knee-jerk reaction of SBP and the government in the KASB bank episode led to a panic-induced mini-run on the smaller banks for a few days, putting them under pressure.

As a related aside, it is important to point out that, even though some of the smaller banks were short of meeting SBP’s laid-down minimum capital requirement, the MCR is arbitrary. While the MCR was introduced by SBP to ensure sufficient liquidity to cover periods of stress on a bank’s deposit base, it was set at an unrealistically high level. Part of SBP’s design at the time appeared to be to ensure that instead of a banking system with a full spectrum of large to small banks, the smaller banks merged with each other or with their larger counterparts, leading to a banking system composed of large and medium-sized banks only.

The finance ministry is increasingly encroaching upon the central bank’s autonomy.

While there is considerable merit to this approach, with SBP also showing remarkable forbearance over the past few years to banks not being able to meet this requirement, it is important to note that rather than requiring extraordinarily high capital buffers from banks, beyond a point, central banks themselves provide that comfort with balance sheet support.

(In any case, the argument about the MCR is academic now. In a ‘breaking’ development, it can be reported that some of the more talked about smaller banks that were well short of the minimum capital requirement have now been injected with the required capital by their sponsors/outside investors).

Also read: KASB Bank placed under six-month moratorium

Nonetheless, a consequence of SBP’s handling of the KASB affair has been the setting in motion of not just a temporary strain on the deposit base of smaller banks, but a real possibility of a steady, more sustained erosion via a perceived “flight to quality” in which the depositors start shifting their deposits to the largest banks.

To pre-empt such a likelihood, SBP should support and protect the vulnerable banks by reiterating in the firmest and most visible way that it stands, as an underwriter with almost unlimited resources, behind the combined balance sheet of the banking system. The silence from the central bank at a delicate time such as this is incomprehensible and professionally indefensible.

Even though the smaller banks represent a fraction of the banking system’s total liabilities, the inter-connectedness of the financial system means that the risk of contagion is very high from either the outright failure of one institution or the inept handling of a developing situation by the regulator. This was amply demonstrated in 2008, in the incipient stages of the global financial crisis, when the failure of Lehman Brothers had a domino effect that ran through the global financial system and choked the international money and credit markets on an unprecedented scale.

Banking crises have large externalities and impose huge costs on the wider economy, wherever they have occurred. The costs accrue from not just the direct recapitalisation of the financial system, but from the gradual rebuilding of trust and confidence in the system that can take several years. From the banking crises in Latin America in the 1970s and 1980s, to the collapse of the savings and loans (S&L) institutions in the US to Sweden’s banking crisis in the 1990s, the costs have varied from an estimated 5-7pc to 30-40pc of GDP.

The recent incident in Pakistan unfortunately points to a larger developing problem — a problem not with the balance sheets of the banks, but with the undermining of the capacity of the central bank as a regulator. After jealously (and zealously) guarding its hard won independence since 1997 with a string of competent, professional and well-regarded SBP governors, the central bank’s autonomy has been increasingly encroached upon by the Ministry of Finance over the past year or so.

The finance bureaucracy’s insatiable ‘mission creep; has seen them take over the functions of several ministries in the recent past, most notably planning; however, in a setting of fiscal dominance, it is the central bank which is the biggest target. In many parts of the world, the ministry of finance views the central bank as little more than a printing press for the government.

Till the late 1980s, the Ministry of Finance regarded SBP as an adjunct department, and called the shots on the appointment of the governor and directors of SBP, as well as the presidents and directors of the banks. Those days seem set to return, as the finance bureaucracy has seen off attempts since 2009 under two different IMF programmes to pass legislation for enhanced autonomy of SBP. The undermining of SBP’s independence has also seen the creation of Sindh Bank — a notoriously bad idea under a corrupt-to-boot government — and the parachuting of several directors onto SBP’s board with conflicts of interest the size of Russia.

Without a robust demonstrated commitment to SBP’s independence, the government will be doing a long run disservice to Pakistan’s financial system.

The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.

Published in Dawn, December 12th, 2014