ishrat husain : regulatory strategy of the state bank of pakistan address delivered by mr ishrat husain, governor of the state bank of pakistan, at the 18th annual general conference on pakistan society of development economics held at islamabad on 15 january 2003. * * * the two major determinants of functional efficiency of financial system are market structure and the regulatory framework and the challenge for any central bank is to strike a right balance between the two. over regulation can stifle financial innovation while an imperfect market structure can impair the efficiency of the system and penalize the consumer interests. market structure consists of the degree of competition, and interlocking control between financial institutions and business enterprises as well as the degree of specialization within the financial sector. it is influenced by the internal organization and management of financial intermediation. these in turn, are affected by the degree of government ownership and control. the regulatory framework includes regulations imposed both for monetary policy as well as prudential purposes. an adequate framework can help ensure financial stability by reducing the probability of bank failures and the costs of those that do occur. regulation is about changing the behavior of regulated institutions because unconstrained market behavior tends to produce socially sub - optimum outcomes. the regulator therefore has the responsibility to move the system towards a socially optimum outcome. the strategy followed by the state bank of pakistan aims at improving the market structure and competition on one hand and optimizing the overall regulatory regime on the other. the steps taken to stimulate completion and improve the market structure consist of lowering entry barriers, abolishing interest rate ceilings, privatizating government owned banks, promoting mergers and consolidation of financial institutions, enlarging the economies of scope for banks, liberalizing bank branching policy, and removing directed credit regulations. the so called dichotomy between regulation and market mechanism is in practice a false one. there needs to be appropriate internal incentives for management to behave in appropriate ways and the regulator has a role in ensuring that internal incentives are compatible with the regulatory objectives. market imperfections and failures, information asymmetries, externalities and moral hazards associated with safety net arrangements make it difficult in developing countries for incentive structures within financial institutions to be aligned with regulatory objectives. let us first define as to what the regulatory objectives of the state bank of pakistan are. these can be summarized as : ( a ) avoiding adverse selection in bank entry by ensuring that individuals likely to misuse banks do not get bank

2 billion in the capital and financial account compared to $ 2. 8 billion last year. most of the surplus emerged from debt flows as the equity flows were impacted by outflows in scra restricting the net inflow to us $ 124. 4 million during july - 21 to november 2007 and postponement of launching of new privatization. given the commitments in pipeline, momentum in foreign flows will pick up further in the last quarter supported also by the floatation of global deposit receipts whose timing is now coordinated with the settling of domestic scenario and world financial markets which currently exhibit high spreads. strong economic activities along with increasing foreign exchange flows have resulted in visible changes in the foreign exchange market in recent years. in fy07, the foreign exchange market grew substantially in both capacity and volumes. market volumes of foreign exchange transactions grew steadily during the year, and reached us $ 68. 5 billion in q4fy07, compared to us $ 55. 4 billion during the same period last year. sbp took a number of initiatives in response to the changing market dynamics. the business hours for the foreign exchange market were extended in january 2007, thus enabling the banks to cater to their customers ’ needs more effectively. in addition, the bases for calculating foreign exchange exposure limit ( feel ) of banks was revised from 10 % to 15 % of their paid - up capital in march 2007, which increased the overall exposure limit of the commercial banks from us $ 200 million to approximately us $ 325million, thus facilitating banks to more effectively manage and price large volume transactions for their customers. the usd / pkr exchange rate continued to be market - determined, and any market intervention is always aimed at moderating the rate of change or diluting any excessive volatility in the exchange rate, rather than establishing any level for it. sbp as a policy doesn ’ t target any specific exchange rate level and the rate is driven by prevailing demand and supply conditions. the stability of the exchange rate, though with healthy two - way volatility, has helped bring more confidence to the international investors to attract long - term investment into the economy as well as to our local corporate to amicably price their goods & services. on the current fy ’ 08 ytd basis, pkr showed marginal weakness against the usd with a point - topoint nominal depreciation of about 1. 28 % as compared to depreciation of 0. 25 % and 0. 97 % in the last two fiscal