Whenever responsible financial analysts decide to look at the current lending scenario in Pakistan, they will surely wonder why the Pakistani banks, especially the private banks, think it is a good idea to be loaning most of their funds to the Pakistani government. Because given the precarious financial health of the Pakistani State, it is precisely the governments borrowing where the risk lies and, therefore, any assumption by the bankers about a relatively risk-free status of a sovereign debt is nothing but a fallacy. What to talk about Pakistan, even in the developed economies of Europe and the US, the financial institutions are quickly learning that their policies like, repackaging subprime securities into triple 'A bonds or treating Western sovereign debt as a secured lending that required no provisioning, were nothing but big mistakes What nearly all the financial institutions around the globe are realising is that their approach during most part of the past few decades has been wrong where they took it as a key axiom of 'investing: That most Western sovereign debt was in effect risk-free and thus, by and large, expected to trade at relatively undifferentiated tight spreads. Now, of course, such an assumption is being exposed as being incorrect. Examples of the Greek 'haircuts, or the scales of future losses now being implied in the credit derivatives markets for Portugal, Ireland and Italy serve as a stark warning that placing ones safe bets on governments may, in fact, just turn out to be the very cause for ones sinking. In the lending portfolio of Pakistani banks, we are also witnessing a very unhealthy and a rather dangerous trend emerging over the last five years or so. The State borrowing has been growing at a very rapid pace crowding out the private sector, which by some accounts has already reached an alarming level of 70 percent of every Rupee lent. The mix of the lending basket looks scarier when on a closer look one realises that even the meagre private sector borrowing for most part is in effect also being driven by the government. For example, the banks have extended nearly Rs500 billion to the private sector power generation endeavours, the performance of which, in turn, largely hinges on the governments own performance, policies and political preferences. A shift in government priorities, corruption or pure mismanagement of the sector can bring these companies down, thus compounding problems of the non-performing loans being currently faced by the banks. Now without going into the reasoning and history on how a poorly planned privatisation policy on the national financial institutions over the last two decades has landed us in an uncomfortable position - where overtly these privatised banks may be showing healthy financial results, but in essence they have not only compromised monetary options available to the Central Bank, but have also landed in the laps of managements, which have failed to successfully meet the challenges on conflict of interest, developing prudent product mixes for long-term stability of the Pak economy and in playing their due role by intangibly influencing governmental economic policies towards a healthy and equitable national growth - the onus still mainly lies with the failure on part of the State Bank of Pakistan (SBP) to act as an effective regulator. It is the primary responsibility of any central bank, as an autonomous and independent institution, to safeguard the national currency, maintain a balance between inflation and growth, provide a vision and direction for investment (domestic and foreign) to flourish, and ensure that in all this the national financial institutions operate to a game plan that is in sync with the countrys economic aspirations. As the economic turmoil mounts, forcing a paradigm shift on investors preference to invest in Pakistan, the intriguing question now is whether or not we are also on the verge of a paradigm shift in the regulatory domain of the SBP? About time the assumption about sovereign debt being debt free is scrapped as acting the pillar of the entire regulatory structure and this not only by the SBP, but also by the entire banking system. A tough ask, however quite doable since traditionally our central bank has consciously or unconsciously been taking its operational guidelines from the Western central banks, who are also now in the process of adopting this very change in their mindset. The history in this regard is quite deep-rooted and dates back to when regulators in the West drew up the Basel I capital adequacy framework in the 1980s where they gave Western sovereign bonds a zero risk weighting, in terms of how the capital is calculated. Though this was subsequently modified in Basel II, to give banks some theoretical discretion to raise reserves against sovereign risk, the policy of zero-risk weighting in practice pretty much continued. Ironically, in the post-subprime turmoil period, the practice actually got reinforced because Western regulators started demanding that banks raise their holding of liquid and safe assets and - you guessed it - these safe assets being referred to were nothing, but government securities or in reality government debt Pakistans case is no different. However, a behind the scenes debate has now started (with the International Monetary Fund in the lead) on what risk-free means in regulatory systems. In October, Herve Hannoun, Deputy Director General of the Bank for International Settlements, gave a fascinating - and startling - speech which called for a shift from denial to recognition of sovereign risk in bank regulation to help to restore confidence and foster fiscal discipline. More importantly, Hannoun wants banks to incorporate realistic assessments of credit risk when they make reserves for sovereign debt and calculate capital adequacy. So what is the lesson here for Pakistan? The broad answer is that if such reforms get implemented and the above ideas also gather pace in Pakistan, there could be huge positive financial implications in the longer term. They being: First, we will see more realistic assessments of sovereign risk (i.e. perceived risk by banks on lending to the government), which would force the banks to hold more capital, and raise sovereign borrowing costs. Meaning, it will automatically impose the much yearned for financial discipline by putting a check on the mad borrowing spree of the government, as its borrowing cost increases and the banks lending ability to the government gets curtailed. Also, this will help avert the phenomenon of the government crowding out the private sector. Second, it will be very prudent for the sustainability of the banking sector, because it is becoming more and more evident that the rising risk to banks solvency is, in fact, more from the government than the private sector. And finally, that this will hopefully straighten up the central banks act, as the changes would force it to change on how it conducts money market operations, and take a tougher stance on not just the obviously impaired debts, but also on all lending and investments (domestic and foreign treasury schemes) that carry a high potential risk. The writer is an entrepreneur and economic analyst. Email: kamalmannoo@hotmail.com