SYSTEMS in Pakistan often operate below potential. We could be close, but remain mired in red tape, beholden to power structures and burdened by hidden and friction costs. Despite an educated middle class and a growing youth bulge, we barely make a dent in the world. Our banking se ctor is no exception.

Banks are crucial to capital formation, documentation and digitisation of the economy. Implementers of monetary policy, banks are the first port of call when it comes to improving national savings rate, international trade or private sector credit.

Without healthy banking, standards of living or the GDP will not improve.

So why isn`t our banking there yet? One could be forgiven for believing that our banks are creating all the value they can, based on the recent national debate on banking profitability. However, Banking on our Banks, a joint analysis by CERP and Alchemy Technologies, asks if we are looking at the right benchmarks for evaluating banking competitiveness.

If we shift our gaze to banks in similar markets, there is a widening performance gap. Consider India`s HDFC bank. Twenty years ago, HDFC and HBL were comparable in size. In 2024, HDFC ranks 11th globally by market capitalisation. The closest Pakistani bank is at number 394. HBL stands at 477. While the volume of reserves, market size and regulatory contexts must be acknowledged, it speaks to the impact of the decisions made by both banks.

Our best banks reveal similar shortcomings in efficiency, profitability, and growth, when measured against their peers in the region who compete by focusing on growing advances with innovative products and technology-driven improvements to credit allocation and disbursement. Pakistani banks focus on investments and returns on government debt. The outcome of both choices is clear.

When we widen our lens to include context that our banks operate in, course correction becomes urgent. By conservative estimates, frictional costs in Pakistan`s tax collection system cause leaks of Rs2 trillion every year, including the opportunity cost of currency in circulation (Rs9tr) and noninterest-bearing current accounts (Rs6tr).

Part of the challenge in our over-regulated banking sector is the emphasis on safety, minimising risk at the cost of innovation. Innovation results from a desire to change but often breaks things. When safety is the prime motivator, breakage becomes a four-letter word.

For decades, the regulator has driven banking innovation ATMs, national connectivity, faster check clearance, branchless banking and now digital and mobilebanking. Yet many believe this top-down approach with a focus on safety is restricting risk appetite and growth.

Banks are incentivised to lend within well-trodden paths, prioritising uncompetitive sectors like energy, agriculture, and textiles while ignoring high potential industries. A banking-specific mutation of the `Dutch disease`. Absence of competition discourages new product development and the ability to bet on new sectors.

Cumbersome approval processes and predictable returns deter innovation with both the regulator and within banking boards.

We need market-driven incentives, responsive regulators, forward-looking boards and a sandbox approach to experimentation. Otherwise, banks will continue to prioritise comfort lending over bold decisions necessary for economic transformation. Small and medium enterprises are the backbone of economic growth but remain a banking stepchild. Export focused borrowers pose a different challenge. Their tech focus makes them asset-light and talent-heavy making them unsuitable for assetbacked loans. The same is true for the growing low-cost private school market. Partly informal, partly under the radar, it doesn`t fit within conventional credit frameworks.

Is it just burdensome complianceand underwriting requirements that deter banks? Or is there more to the equation that prioritises larger exposures? The mystery element `X` is scale. We scaled the liability side but left advances behind. Datadriven models, market-relevant pricing and customer-driven products are one solution.

Digitalisation, reducing inefficiencies and building anew come with a price tag.

There are regulatory burdens to overcome, skittish investors to pacify, unprecedented economic challenges to confront. The question is not if these challenges are surmountable they are, but if we are willing to take them on. The path forward demands courage for regulators to rethink models, for banks to take calculated risks, for policymakers to align incentives with innovation.

But only systems worthy of Pakistan`s extraordinary potential can help us reach it. • Jawwad Faúd is professor of practice at IBA, Karachi. Rimmel Mohydin is an associate directoratCERP.