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    8 views7 pages

    Part 8 Financial Sector Reform (Chap 1,2)

    Uploaded by

    Muhammad Ali

    Copyright:

    © All Rights Reserved
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    of 7
    - Part Bight Chapter 1 Learning Outcome Financial Sector Reforms Importance, Scope and Impact By the end of this chapter you should be able to + Discuss the importance and scope of financial sector reforms ‘= Describe how these reforms impact the overall workings of a financial system, Reform of the Financial Sector in Pakistan 146 Banking in Pakistan has largely been dominated by government-owned institutions and has accommodated the financial needs of the government, public enterprises’and the private sector. Public sector dominancy, among others, led to inefficiency in the banking sector. The economic efficiency of the banks remained low so that a low level of savings/and investment in the: private sector resulted in low growth. These problems include concentrated: ‘ownership of financial assets, high taxes, and a narrow range of products. The reform of the financial sector in Pakistan should be examined in a macroeconomic context, against the backdrop of the overall strategy af reforms implemented during the last decade and the strengthening of the Cental Bank's ‘capacity to regulate and supervise the financial sector. It was only when the ‘macroeconomic situation took a tum for the better that structural reforms were ‘vigorously pursued and the State Bank of Pakistan achieved autonomy and ‘competence that the financial sector began to show some demonstrable results Without these pre-requisites in place, it is hard to imagine whether any meaningful progress could have been possible. Bariking) Seotor reforms cannot ‘be successfully implemented and sustained in the absence of a favorable and stable macroeconomic environment: Pakistan's track record in macroeconomic ‘management and governance during the 1990s was dismal AA strong regulatory and supervisory system is extremely vital to cope with financial crises and promotes the efficient functioning of financial markets Therefore the challenge isto formulate an appropriate regulatory framework that ‘enables the banking aystem to be more resilient to insolvency. In addition, timing, sequencing and speed of restructuring measures are very imporiant. Financial sector reform usually refers to two distinct but complementary types of change that are needed in order to establish a modern financial ‘stem capable of acting as the "brain of the econotiiy” and allocating the economy's savings in the most productive way among different potential investments. Fist i the liberalization of the sectot: putting the private sector rather than the government in charge of determining who gets credit and at what price. Second, establishing a system of prudential supervision designed to restrain the private actors so that we can be manila and Banking Roplaons | Retrence Rook 2 Inport, Scope an Impact reasonably sure that their decisions will also be broadly in the general social interest. Liberalization without supportive arrangements for proper supervision can easily lead to anti-social behavior by bankers, of the forms referred to as "looting and gambling”. This provides a paradigmatic example of the more general proposition that establishment of a market economy requires a change inthe role of government rather than the elimination of all government action, withthe new role being one that foeuses on providing an environment within which the private sector can act effectively, “7 Part Bight Chapter Learning Outeome 148 Financial Sector Reforms Deregulation and Liberalization of the Financial Sector By the end of this chapter you should be able to = Define what is meant by deregulation and liberalization of the financial sector ‘= Discuss the concept of and rationale behind deregulation and, liberalization of the financial sector Deregulation is the removal or simplification of government rles and regulations that constrain the operation of market forces, Deregulation dos not me climination of tas against fraud or property rights but eliminating or reducing government control of how business is done, thereby moving toward a more Inisez- fair, free market Financial Liberalization ~ “The six differ dimensions of financial liberalization are considered to be: =) The elimination of credit controls = The deregulation of interest rates = Free entry into the banking sector (or, more generally, the financial services industry) + Bank autonomy (allowing bankers rather than bureaucrats to decide ‘whom to employ, at what wage rate, where to open branches, et.) =) Privatization of banks = Liberalization of international eapital lows Elimination of credit controls and deregulation of interest rates means allowing the market to handle the process of intermediation between savers and investors, There is no intervention from the government or its agencies. ‘There are two distinguishable effects. First, the liberalization of interest rates has typically resulted in their increasing above the low levels that are usually found in repressed financial systems. Advocates of financial liberalization argue that this will increase the level of saving, and therefore investment, and so promote growth, There has been much empirical work examining this thesis in recent years, The evidence suggests that the level of saving as little clasticity with respect to the rate of interest. However, while the overall level of saving does not systematically increase when the interest rate rss, more of the saving that does occur is placed in the financial system, so that financial depth does rise, and hence more of a given level of saving is intermediated through the formal financial system. That will bring a benefit if the formal financial system is better at allocating savings than alternative ‘mechanisms (such as the informal financial system or buying gold). The higher interest rates will also benefit savers, which should be counted a social benefit to the extent that savers tend to be less wealthy than investors. Francia ys and Banking Replations | Reference Book 2 ‘The other half of the inermediation function is to seleet those potential borrowers who will receive credit’ In a repressed financial system this decision is largely made by the government, while in the market system it is made by bankers. It is important to understand that one does not want banks to lend to those who promise the highest returns, for they will almost always be the most risky borrowers. Nor should they seek to lend to the least risky. for the most rewarding investment prospects almost inevitably involve some element of risk. ‘The ideal is to lend to those who offer the prospect of a good return, given the tisk involved. One wants a bank to be free to charge an intrest rate that reflects, the riskiness of each particular loan, and then make a prudent portfolio choice that will bring ita good overall return for @ modest level of risk, after limiting its risk by choosing a diversified portfolio. Consider next the rationale for free entry into the banking sector. This is very similar to the rationale for free entry into any other sector. The threat of actual or potential competition Keeps the interest spread down and disciplines banks into operating efficiently, and eliminates any banks that are not capable of keeping. ‘up with current standards of efficiency, The entry of foreign banks can bring ‘modern techniques into the industry. Free entry avoids political favoritism being. used to award rents to friends. However, there is also a serious intellectual case against free entry, which stems from the notion that a substantial positive franchise value induces selfdiscipline in lending. The argument is that a bank, that does not have a stake in being able to continue to lend in the furure will hhave an incentive to make risky loans, taking gambles that will yield it big gains if things turn out right but impose big losses on others (the goverment or depositors, depending on whether bank deposits are effectively guaranteed or hot) if things go wrong. But if it knows that it can expect to earn a stream of” Qquasi-rents from its reputational capital in the future, it will not risk its reputation. Prudence may thus suggest maintaining a balance between the free entry. This seems an appropriate place to acknowledge that one other restraint on financial liberalization has sometimes been advocated in the interest of ‘maintaining a positive franchise value of the banks: This is to place a ceiling on the interest rate that banks are allowed to pay on deposits. An interest rate modestly below the competitive level will increase the profitability of banking, and thus the franchise value of the banks, without having much effect on saving, (though it will make savers somewhat worse off) If the ceiling is set equal to the treasury bill rate, such a regulation will also prevent banks bidding for deposits by offering more than the risk-free interest rate, an offer that can only be justified on deposits if they are recognized to be risky or elseif effective deposit insurance provides a subsidy to the bank. ‘Bank Autonomy ‘The ease for bank autonomy is straightforward, One cannot expect bankers who are not allowed to manage their own banks by deciding whom to appoint, and how much it is necessary to pay to motivate and retain good staf, to take responsibilty for the outcome of their operations. One wants Dereultion nd Liberation of th Financ Sector i 150 ‘bankers to make their own decisions, guided perhaps by general rules, but making inherently discretionary decisions like these for themselves so that the responsibility for bad outcomes is unambiguous. Privately-owned banks will necessarily have autonomy; which is a part of the case for privatizing banks? Another consideration is that a publiely-owned bank ‘may be subject to pressure to allocate loans according tothe political interests of ‘governing politicians rather than in accordance with commercial considerations. But perhaps the most important consideration stems from a different role of banks, Allocating lending between altemative prospective borrowers is only part of their job: they also need to monitor the use made of their loans to maximize the probability that they will be repaid on time. In some countries, this monitoring is done in an arms length way. A bank is able to observe the eash flow of its borrowers, and can threaten not to renew loans falling due iff they see a borrower’ financial position weakening. This pressures the borrower into cutting back its activites. In Germany and Japan, in contrast, banks play an active role in the corporate governance of their major borrowers, with bankers often sitting on company boards, thus permitting them to play a direct role in steering the policies of their borrowers in a way that will ensure’ they can maintain debt service. The relative virtues of these to approaches remains an unresolved issue, but some economists who believe that the Anglo- ‘Saxon model is the most suitable one for advanced countries also believe that the German-Iapanese model is preferable for countries where financial talent is spread thinly and hence most effectively deployed by placing qualified bankers ‘on a number of company boards. ‘These measures are meant to maintain stability of the financial system so that the overall economy of the country can be stabilized: One of the fears ‘voiced by early critics of financial liberalization was that, in the absence of the right to decree credit ceilings, the central bank Would have no effective: policy tool with which to limit bank lending, resulting in a loss of monetary control and hence macroeconomic instability, These fears have not been realized in most countries that have liberalized their financial system. On the contrary, most countries have found that after a rather short space of time they were able to Utilize indirect methods of monetary control (ic. open- market operations, management of an official discount rate, and perhaps variations in reserve requirements) to” miaintain’ more’ Sensitive monetary. control than had proved possible with the old direct methods, in which ‘bankers so often had an interest in circumventing their orders. Prudent Supervision Banks cannot be allowed a free hand in maximizing profits. One reason stems from the unusual balance sheet of banks, coupled with the problem of asymmetric information: Because banks have a high debtiequity ratio. 2 relatively small loss of debt service can push a bank into a position of possible {insolvency (nogative-net'worth). Unless the bank has a high franchise value stemming from an expectation of being able to make a stream of profitable loans {in the future, this creates an incentive fora banker to engage in what is known as Financ Systems snd Bashing Regulations | Reference ook 2 "gambling for redemption’. As a private banker sces i, his only hope of remaining a banker is to make high-risk, high-retur loans. If the loans pay off, his bank will be solvent again ("will be redeemed”). If the loans go bad, he will bbe no worse off, since his bank will still go bust. Thus all the potential gains facerue to the banker and all the losses fall on someone else (the government if bank deposits are guaranteed either explicitly or Because the bank is judged "too big to fail", oF the depositors otherwise). A banker faced with these incentives ‘would be rational ithe did not gamble with his depositors’ money. Moreover, it is usually not obvious to outsiders when this first occurs (this is the asymmetric {information}, so that in the absence of prudential supervision there is no one to stop him gambling for redemption. Even a supervisor may have difficulty in judging whether new loans are being extended defensively rather than in support of promising new investment opportunities. ‘A second reason why supervision is needed is that private bankers would often bbe tempted to lend to themselves or their friends in the absence of any restraint, and again usually nobody would be any wiser until it was too late, because of asymmetric information, Such ‘looting" (ending to oneself or one's friends without a reasonable expectation of repayment) can arse for several reasons. At the crudest, it may reflect an inability on the part of the banker 10 distinguish between funds entrusted to him as deposits and his own personal property, but it need not be that crude. It may happen because other enterprises in which the banker happens to have an equity stake are running into hard times, andthe only hhope he can sce of saving them is to extend eredit from his bank (this was an ‘important factor in Argentina during their frst liberalization attempt in 1978 82). Or it may result from a very human tendency to: be over-optimistic about? the probability that one's own investment projects, or those of one’s friends, will turn out well. Whatever the reason, experience has shown that banks are all 100, likely tobe subject to looting in the absence of supervision. ‘A supervisor can help avoid such situations arising in several ways. Fits, he may know more about the bank's situation than outsiders can normally be expected 0 know, which may enable him either to restrain the bank from making addtional risky loans, or restrain it from paying dividends, or evento force it into making only specially safe loans (c.g. lending only to the government), when its net worth

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