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 capitalised, 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 specialised 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 per cent 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 favour 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 favourable long-term outcomes, but to what favours 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-globalisation 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 per cent in China, 70 per cent in India, and in Russia and Brazil about 45 per cent. But there’s no ‘lock’ on market share. Private and foreign banks are encouraged, and competition raises competence in the SBs.

BRICs focus heavily on government DFIs. China has CDB, and giant ABC, for agricultural and project lending. BNDES in Brazil finances 40 per cent of Brazil’s industrial project and infrastructure lending; Banco de Brasil is the leading provider of agricultural finance. India has three infrastructure lenders, mainly in the PPP mode, at the centre. States have their own versions.

Reservations remain. SBs suffer degrees of financial ‘repression’ through forced lending, but also receive covert and overt subsidies — the degree is hard to gauge. Nevertheless, their contribution to development is increasingly well-accepted.

Turning to Pakistan. We have a predominantly privatised banking sector. Against the general public mandate in EMs, the absence of DFIs and the small size of the banking sector stand out. Against a deposits/GDP ratio of 65 per cent for EMs, Pakistan is 29 per cent, down from 35 in 1998, when privatisation commenced; private credit down from 27 to 16 per cent vs an EM average of 50 per cent/GDP. Only 11 per cent of the population has access to banking services, significantly behind India 48 and Bangladesh 32 per cent.

Rates paid to depositors suffer exceptionally high discount to lending rates, seven and eight per cent. Lending to government/public sector is up from 30 per cent of total loans in 2006 to 48 per cent now — at an aberrational financial cost for government, and financing not investment but operational losses.

Incongruously, while remaining huge in operating domestic businesses, government has forfeited key development tools.

The old DFIs (PICIC, IDBP, NDFC etc) have not been replaced, and their activity not taken up by private entities. Capital markets for debt barely exist — due as much to a distorted (though remediable) structure for government debt, as the reluctance of banks to develop activity that would shrink their outsize spreads.

How can the banking framework here redeem its mandate for economic development, diversified financial markets and rapid financial inclusion? Briefly, regulators have to galvanise competition, and with government, revive development lending.

Given the history, new institutions under state control in Pakistan are not desirable. If the private sector will not lead development, government should address the gap through forms of PPPs. Many successful models exist in the larger EMs.

Regarding financial competition, the heavy hand of our big banks can only be challenged by public-debt markets to split the banks’ spread and produce lower borrower rates and higher investor returns. Losing ‘rated’ borrowers to public markets, banks will replace them with lending to SME, agriculture and consumers. To replace deposits lost to higher yielding debt via funds, banks will hasten neglected deposit mobilisation.

The same ‘disintermediation’ of banks, should occur with government — public markets will lower interest cost once government is no longer ‘captured’ by banks being the almost sole buyer (non NSS).

Other areas need attention. Banks have not pursued LBOs, venture capital etc, to encourage long overdue consolidation in our fragmented industry. A step forward here would be a corporate restructuring institution. A start was made when the Corporate Restructuring Act was drawn up under Shaukat Tarin’s tenure, providing facility in law for fast corporate reorganisation. It has not been finalised.

Regulators and government can assist in the realignment of the banking sector closer to its public mandate. Transformation will occur over time — but it is eminently possible.

The writer is a former governor of the State Bank of Pakistan.