Minimum Capital Requirements for Banks

Recently the central bank State Bank of Pakistan (SBP) increased the minimum capital requirement (MCR) for the banks operating in Pakistan. As per earlier circulars, banks were required to achieve Rs. 6 Billion as MCR till December 31, 2009 which at the prevailing exchange rate came to around US$ 100 million.

However, as per the latest notification,

Under the existing instructions, the banks/DFIs are required to have the MCR at
Rs 6 billion by December 31, 2009. According to new instructions, the banks will have
to raise their MCR to Rs 10 billion by December 31, 2010, Rs 15 billion by December 31,
2011, Rs 19 billion by December 31, 2012 and finally Rs 23 billion by December 31,
2013.

All newly-licensed banks will henceforth be required to meet the paid
up/assigned capital requirement of Rs 23 billion before commencement of their
operations.

Under the current circumstances, when the economy of Pakistan is under duress and there are no signs of rapid growth in near future, this will lead to consolidation among banks small as well as large resulting in halving the 40 plus banks that currently operate in Pakistan. No shareholder will see a benefit in putting in more money as equity capital as in a stagnant economy, increasing the MCR will result in negative return for equity holders.

AB Shahid, an ex-banker whom I respect a lot, has done a decent analyis of the measure in a recent issue of Dawn,

There is some logic in the move. In the unfolding scenario some small banks must merge to create viable entities, but it also raises some questions: is SBP anticipating rapid economic growth and credit expansion or a big rise in bank risk, or having fewer banks to watch will permit SBP to take on NBFIs as well without increasing its current capacity, or curbing cartelisation by mega banks isn’t a challenge now.

I believe its the latter, that SBP does not have the capacity nor the capability to monitor such large number of banks. So to make its monitoring job easier, it is forcing the banks to merge, a wrong way to achieve its objective.

Higher capital indeed enhances loss-absorbing capacity but avoiding losses — the prime objective — requires improving internal and external institutional arrangements to monitor and control risk i.e. inculcating commitment, prioritising expertise and enforcing stiff regulatory discipline.

This is what has been proven time and again both in western financial sector as well as Pakistan. The largest banks in Pakistan are not necessarily the most loss free. For example, UBL is amongst larger banks for Pakistan. Recently, it had been earning significant profits from consumer banking products and was reporting phenomenal results. However, once the economic growth stagnated, it has suffered huge losses in its consumer banking business. Similarly, Standard Chartered (largest foreign bank) has minimized its consumer banking business after incurring significant losses. Compared to it, losses in relatively smaller banks such as Soneri, Bank AlHabib and even Mybank( a nobody) has been contained as due to their smaller size they had better controls and risk management systems in place.

Evidence suggests that the factor causing these failures is lack of relevant experience among central bankers because most of them have only academic, not practical knowledge of running commercial banks.

Though I am not familiar with bio-data of people running SBP but based on the recent handling of events, I don’t have much confidence. However, I would disagree with the author that having an experience of running commercial banks reduces those risks. The recent Treasury Secretary of US is Hank Paulson is a celebrated Investment Banker and under his watch we have seen the end of investment banking as we know it wherein all this time he was in a state of denial.

In a country like Pakistan, smaller banks is what we need as they try to make profit by reaching out to smaller segments of society such as SMEs while helping them to grow. If they consolidate and become big, they will run after the larger corporate where a single transaction can add much more to their top line without the associated costs of having larger branch network.

Having small as well as large banks is what makes the banking sector of Pakistan resilient. All the banks have different target segment, different risk profiles and as such unless they are faced with a systemic risk, a single event will not lead to the collapse of the whole banking sector. But once the banks merge and will become big, they will all modify their exposures to have similar exposure to similar sectors such that if a particular sector fails, it will take down either none or whole of the banking sector.

Once the banks become large, they become bureacratic, they build cartels and are less customer friendly. This is still evident from the rate of returns offered by largest banks to the depositor which in real terms is negative. Smaller banks are customer friendly and offer attractive returns to the customer which induce savings which is what is required in the present circumstances.

Its my belief that SBP despite forcing BASEL II down bank’s throats, SBP does not have the capacity to monitor and manage the risk of banks. As such, to make its job easier, it has decided to impose arbitrarty capital increase requirement in hope that this will some how make the banks safer and less prone to failure.

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