The financial system in Pakistan is predominantly bank based: about 75-80 per cent of the total financial assets constitute of banking system assets.

A factual assumption in the banking industry is that negative externalities exist in banking. A negative externality occurs when decisions taken by banks impose costs on the depositors, which the bankers have not accounted for in the decisions they take.

An example is the existence of informational asymmetry between the bank management and depositors. The source of this asymmetry is that the bank management knows its business strategy and financial portfolio better than anyone else in the economy. Depositors, on the other hand, are the least informed; therefore, they cannot price the risk appropriately.

This information asymmetry allows bank managers to take decisions (bad loans) without taking fully into account the effects of those decisions (losses inflicted) on depositors.

The longer this externality exists; there will be less intermediation, which will lead to market failure and eventually instability of the financial as well as economic system as a whole. One of the primary goals of bank supervision, then, is to reduce this information asymmetry and thus negative externality.

Bank supervisors employ a variety of frameworks to carry out supervision. The frameworks they use employee various methods to ensure that bank management takes into account the effects of its decision-making on depositors.

A principle and common component used by banks supervisors is to require banks to hold sufficient reserves against expected (provisions) and capital against unexpected losses. The purpose is to prevent bad spill over effects of private decision-making on the broader depositor base, which leads to stability of the system.

In this way, bank supervisors are not only able to prevent market failure but are also able to keep the system stable and running.

Besides capital indicators, other methodologies such as liquidity indicators, loan-to-value (LTV) ratios and disclosure requirement are also used to ensure the stability of the system. Clearly, some of these are borrower targeted (e.g., LTV) and some are institutions specific (e,g disclosure requirement).

How a bank supervisor chooses to implement these tools depends a lot on the structure of banking system, and the ability to pursue its mandate.

Prior to the Global Financial Crises (GFC) of 2007, these tools were targeted primarily on the institutions ignoring externalities that could arise at a macro level.

However, the events that unfolded at the onset of the GFC, showed that market failure could also occur at a macro level. Resultantly, bank supervisors across various jurisdictions are working on macro-prudential policy frameworks to deal with systemic risk more effectively.

The ability of the supervisor to carry out supervision may be constrained by a number of factors. Forbearance and regulatory capture top the list.

The difference between the two is hard to discern due to the overlapping nature of the two problems. Further, how immensely it features in limiting effective supervision remains elusive.

The changing landscape of the financial system and growing influence of technology in banking has augmented negative externalities.

It goes without saying that the change and use of technology has immensely benefited consumers in terms of availability of banking solutions, nonetheless, the accompanied risks and vulnerabilities have also grown in size and stature.

More challenging is the fact that these risks and vulnerabilities have spread beyond the sphere of influence of supervision, so that developing tools to keep them in check has become more challenging and exhausting.

For example, how does a supervisor ensure the risk is appropriately priced in a peer-to-peer lending? That is a question for another day.

— The writer is a Deputy Director, Research Department at the State Bank of Pakistan

Disclaimer: The views expressed by the writer are his own and do not necessarily reflect the views and policies of the Dawn Media Group or the State Bank of Pakistan.

Published in Dawn, The Business and Finance Weekly, April 2nd, 2018