Khalid Mirza is an authority on financial services regulation, development finance, private equity, venture capital, and market risk assessment. He has over five decades of experience including as Chairman Securities and Exchange Commission of Pakistan, founding chairman of Competition Commission Pakistan, chairman SECP Policy Board, Sector Manager East Asia and Pacific World Bank, and senior roles with International Finance Corporation with a focus on emerging markets. In his role as Chairman SECP, he transformed and restructured the institution to enable effective regulation of securities and capital market. During his tenure, the transformative journey helped increase investor confidence.

Given his vast experience with financial market governance, BR Research sat down with Khalid Mirza to discuss the challenges and future of NBFCs in Pakistan. Below are the edited excerpts from the interview:

BR Research: How did NBFCs come to be regulated by the SECP in Pakistan?

Khalid Mirza: Before 2000s, NBFCs in Pakistan were regulated by the central bank. At the time, the central bank was perhaps not very keen at retaining NBFCs under its remit, as the segment was underperforming.

In 2002 when I was the then SECP chairman, a taskforce was formed under the seasoned bureaucrat Mr. Shamim Ahmed Khan, which came up with a formula to redefine NBFC’s regulatory order. A two-pronged requirement was adopted: all non-banking FIs were first required to obtain an NBFC license, along with separate licenses for any of the functions they seek to perform such as underwriting, discounting, or asset management etc. Minimum capital requirements were also issued for each of the functions that the NBFCs sought to perform. Note that this formula has been successfully adopted by many jurisdictions across the world.

BRR: Yet it appears that this formula has not truly delivered in Pakistan, as NBFCs – particularly lending NBFCS – have remained insignificant players in the domestic financial system.

KM: Because Pakistan did not get it right completely. Any FI that takes deposits and lends against those deposits is essentially performing the function of money creation. The securities regulator, SECP, must not regulate a deposit-taking NBFC. Deposit takers must always fall under the remit of central bank, as it is responsible for management of monetary aggregates of an economy.

Capital requirements of non-bank financial institutions should instead be met by issuance of securities. Unfortunately, SECP later allowed NBFCs to take deposits, although the lacuna has been highlighted ad nauseum.

BRR: NBFCs raise funds through issuance of Certificate of Deposits. Are these not same as issuance of debt securities (e.g. TFCs, corporate bonds) in substance, if not form?

KM: That depends on how the instrument is structured. If a CoD is encashable at will, then in substance it functions like a call deposit. A CoD may share many other aspects with debt securities such as tradability in a secondary market, fixed or variable interest rate etc, but it is the encashability that makes it more similar to bank deposits than a TFC or a bond.

BRR: Do you believe NBFCs and the securities market have failed to develop under SECP?

KM: The domestic financial system suffers under onerous regulation. The cornerstone of Pakistan’s regulatory mindset is that the investor knows nothing and must be protected. This has led to a vicious cycle where investors place blame for losses on the regulator.

Take the example of securities market, where instead of encouraging competition and deregulation, a dagger has been put into the heart of competition by delicensing of two stock exchanges. Now, the SECP wishes to create a humongous monopoly by merging remainder players such as PSX, PMEX, and the clearing house into one holding company. Remember, you cannot have a market without first creating the ethos of a market.

BRR: Do you agree that the NBFC segment – particularly lending NBFCs such as leasing and modarabas - have failed to take off under SECP which is arguably a more laxed regulator compared to SBP. In contrast, NBFCs in India are regulated by the central bank and the sector has seen significant growth in the past two decades. Why?

KM: Leasing companies in India can take deposits up to ten times their equity. They also do not have mandatory credit rating requirements. As a result, it makes perfect sense to regulate them under Reserve Bank of India (RBI).

Other than India, globally leasing has successfully developed as a non-banking, non-deposit taking institutions. They raise capital through issuance of securities, such as bonds and short-term commercial paper. They also engage in securitization of receivables, which leasing companies in India cannot do as they are regulated under RBI.

It matters not whether lending NBFCs such as leasing companies are placed under the ambit of SECP or SBP in Pakistan unless the regulatory mindset changes. The regulatory mindset is bent on controlling the market because it believes the market players are irresponsible. Pakistan’s only leasing success story is a company which has innovatively circumvented over-regulation. Most others were set up by those looking for regulatory doles.

BRR: Does that mean changing the regulator will not necessarily overhaul the sector?

KM: The financial sector has two legs. One, commercial banks that are risk averse. Others are risk takers such as merchant banks and investment finance companies. In principle, leasing companies are also risk-takers because they offer near hundred percent lending with limited collateral.

Except for India and South Korea, the risk-taking leg of the financial sector in Asia has failed to develop. To incentivize this segment, the burden of regulation first needs to go. Let me explain that with an example.

Appointment of the CEO of leasing companies is subject to a Fit and Proper Test. The bureaucrats sitting in regulatory bodies invariably approve commercial bankers for this role, even though commercial bankers by training are risk averse. Those ex-bankers then complain how the leasing companies cannot compete with commercial bank’s low cost of funds or lack of collateral availability.

Leasing companies are not supposed to compete with commercial banks; rather, these are supposed to borrow from commercial bank and lease on higher rates of return by taking risks. Orix leasing succeeded because it came up with innovative products such as commercial vehicle (trucks) financing for SMEs. In most cases, it is cashflow based lending, which risk-averse bankers rarely have an appetite for.

BRR: Do you agree that microfinance segment has been more successful because of SBP’s role in regulating microfinance banks?

KM: Microfinance banks in Pakistan are not exactly engaged in micro-lending; they are primarily functioning as banking institutions. The non-banking micro-finance enterprises, in contrast, grew as saplings planted by NGOs and have done micro-lending relatively well in the form of rural support programmes, and poverty alleviation funds.

The microfinance banks are in fact acting as lenders to microfinance institutions; there is hardly any direct lending by MFBs to those at the bottom of the pyramid.

BRR: The central bank has several concessionary lending schemes/programs in line with its objective to increase access to finance for SMEs. Because lending NBFCs are also primarily SME-segment focused, do you believe moving NBFCs to SBP’s ambit may help in accessing those refinance schemes?

KM: Bringing NBFCs under SBP will not lead to a relaxed regulatory environment. As it is, the SECP and SBP compete so far as cumbersome regulation is concerned; these regulators are unfit for promotion of markets.

Coming to concessionary loans, the NBFC segment must not lay the foundations of future growth on refinance schemes. If lending to any SME does not make commercial sense, no bank or NBFC should be coerced into doing so.

BRR: A non-banking function traditionally, do you believe growth of investment banking in Pakistan has been stifled due to its clubbing with commercial banks?

KM: Domestic financial sector lacks specialized investment banks, which are bankers of securities. In fact, investment banks are probably the most essential non-banking financial institutions. Pakistan has been unable to build investment banking because of its reliance on individuals associated with commercial banking.

India on the other hand has been very successful in building investment banks by leveraging the platform already available to brokerage houses. Brokerage houses in India have morphed into investment banks. The same pattern was followed in USA as well as in France. In East Asia, investment banks have failed to build a presence. The investment banks that do exist in East Asia are subsidiaries of some of the largest investment banking entities in North America and Europe.

For investment banking to be successful, it needs to be indigenous for it to become an important part of the local financial industry. Investment banking requires salesmanship and the ability to build and present long-term prospects. The skill set is missing. Instead, commercial bankers and chartered accountants are hired to perform a role they are ill-equipped to perform.

The World Bank has a mantra that various types of financial services platforms only flourish when they are developed in a specialized form. Those that have tried to club these functions through universal banks have not succeeded. At the very least, investment banking arms of commercial banks should be separated into independent subsidiaries, to get them out of the shadows of commercial banks.

Similarly, other financial services such as discount houses, asset management, private equity, brokerage houses, and investment advisory services should grow in their specialized form, especially in the infancy stage. Once a financial system develops, they can then be allowed to cross-sell.