A memorandum of understanding was recently signed between the Securities and Exchange Commission Pakistan and the State Bank of Pakistan to manage systemic risk through a council of regulators.

With no coalescence legislative framework, a similar MoU was signed between the SBP and the SECP in 2009, with the aim of sharing information and carrying out consolidated supervision through a dedicated joint task force as an interim arrangement.

The SBP in consultation with the SECP proposed amendments in legislation to the ministry of finance and a draft was under consultation during 2007-08; however, any further development in this regard is not known so far.

If one very large bank did fail, we may see a domino effect

Let’s briefly revisit historical facts and understand systemic risk.

On April 20th, 2008, after touching an all-time high of 15,760 points, stock prices collapsed. The index plunged by almost 55pc.

The resultant chaos in the stock market had a ripple effect and Non-Bank Financial Companies (NBFC) started defaulting like dominos. Finally, the Development Finance Institution (DFI) and banks also got engulfed in the crisis.

The systemic risk threatened the stability of the financial system; becoming a widespread phenomenon, it impaired the functioning of the financial system.

Impending emergency, a ‘floor’ was placed. While blame for the misfortune was put on the ‘floor’, many experts consider it a scapegoat since the two apex regulators had no common definition of unforeseeable circumstances that warrant corrective measures.

Determining finality of the risk is still unfinished business; even the Securities Act, revamped in 2015, leaves it an open-ended question for the SECP.

While the Council is a significant step towards coordination and information sharing, with no legislative framework – like the Dodd-Frank act in USA — that places restrictions on speculative trading and nexus of the banking industry, the council would be not properly equipped to manage systemic risk.

Under the Banking Companies Ordinance (BCO) 1962 there is no limit on commercial participation in a financial company. A bank may acquire more than 10pc of the capital of the Investee Company or 5pc of their paid-up capital with SBP approval.

In case of shifting risk from shareholders to depositors, the stability of financial system will be compromised. To curtail systemic risk and address conflict of interest a comprehensive legislative amendment is required.

Interconnectedness of financial institutions has been identified as a critical source of systemic risk. All important Self-Regulatory Organisations (SROs) i.e. the Pakistan Stock exchanges, PMEX, Central Depository Company (CDC) and NCCPL should be included to create a broad agreement on the key exposures systemic risk produces.

In the US, the Trump administration has rolled back the Dodd-Frank Act, leaving the world at risk of facing another financial crisis.

International Central Bankers think that already reduced interest rates leave little room to stimulate economic growth. Government debt has also sky rocketed since the last crisis in 2008. These circumstances are conducive to another impending financial crisis.

The question is how Pakistan will be affected by these developments. Two transmitters of an impending financial crisis are trade and stock market.

Besides exogenous shocks, the country has a home-grown problem that may be catalysed with external stimuli. Very-large banks: banks with more than 10pc market share that are ‘too big to fail’.

If one did fail, we may see a domino effect; there are two banks that cumulatively hold about 28pc of the banking industry’s deposits, having significant systemic importance.

A quarterly performance review of the Banking Sector, Q1CY17 reveals that Capital Adequacy Ratio (CAR) of the banking industry has slightly declined to 15.9pc during Q1CY17 from 16.2pc in Q4CY16 but is still well above the minimum required level of 10.65pc.

Banking company’s amalgamation with other associated businesses makes the equation complex. A framework for consolidated supervision, along with proposed amendments in legislation is imperative for systemic risk management of financial conglomerates.

Heterogeneous risk perception would be a zero-sum hand game. Absence of coordination between the SECP and the SBP exacerbated the financial crises of 2008. Arbitrary use of force majeure and ad hoc policies are some of the lessons learned and seemingly forgotten.

The architecture for supervision rests with two main regulators — the SBP and the SECP. A de jure Lead Supervisory Authority with a mandate of consolidated supervision and recommendation to enforcement to the functional regulator is an indispensable part of systemic risk management and best international practice.

The duo of regulators is operative under different legislative pieces. Sharing a common statutory objective of consolidated supervision is not good enough.

It is essential that policymakers show leadership through a strong and coordinated rule-writing process promoting the development of cohesive, consistent regulations.

— The writer is an investment banker and a visiting faculty at PAF Kiet.
adilf39@gmail.com

Published in Dawn, The Business and Finance Weekly, June 19th, 2017