Monetory Policy And Banking Essay

1174 words - 5 pages

Oct. 2009

Banking and Monetary Policy in 2010

Ishrat Husain

Pakistan faced serious economic difficulties in the last few years particularly in 2008 due to high inflation, large current account deficit, dwindling foreign exchange reserves and excessive borrowing by the Government from the Central Bank. Monetary policy was therefore tightened throughout 2009 to bring inflation under control. Policy rate was cut only when signs of moderation in inflation began to appear. It is only in the last few months that macro stability has been achieved with the assistance of the IMF. But paradoxically the global financial crises had very little to do with the domestic economic ...view middle of the document...

Residents were not able to freely convert their domestic savings into foreign currencies and businesses were allowed to invest abroad under tightly restricted conditions. Exotic foreign currency denominated securities and derivative products were not allowed.
Second, the capital adequacy ratios were enhanced beyond the prescribed level of Basle I and financially engineered products having the potential of value erosion were not permitted. Variable capital ratios were introduced to reward the sound and efficient banks and penalize the weak and inefficient banks on the basis of objective indicators determined by the Central Bank.

Third, incentive structure for branch expansion and new business product offerings were linked to the performance of each bank. This in-built transparent mechanism held back the weaker or relatively unsound banks from mobilizing retail deposits. This mechanism was applied across-the-board and if the big banks failed to meet the soundness criteria they met the same fate. Thus the bias towards “Too big to fail” was indirectly contained in this manner.

Fourth, the banks were encouraged to clean up their balance sheets by removing long standing non performing loans that had low or no probability of recovery. The Central Bank evolved a generalized scheme under which the collaterals possessed by the lenders were allowed to be liquidated at their forced sale value and adjusted against the principal amount outstanding. Loan loss provisions were then invoked to set off the residual value of loans outstanding. The Gross NPL ratio of the banking system declined from 25 percent to 6 percent within five years giving a big boost to the profitability of the banks.

Fifth, the cleaning up of the balance sheets, strict restrictions on the off balance sheet contingent liabilities, and the increased profitability of the banks attracted strong international players to Pakistan. As foreign banks were treated at par with the domestic banks and had no restriction on the limit to which they could own equity they rushed in with capital, acquisitions of weaker banks, expansion of distribution channels, new technology and products. Financial services industry was the second largest recipient of FDI and in the peak years the annual flows averaged more than $ 1 billion. Despite the presence of these international banks the domestic regulatory environment kept them away from excessive risk taking and undesirable innovation.

Sixth, the introduction of the private sector into the banking changed the whole human resource profile. There was a gradual transformation from low productivity manual unskilled workers to high productivity educated knowledge workers. This up-gradation and substitution of human resource base, hardly noticed, has made a...

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