N25billion Capital And The Future Of Nigeria’s Banking Industry

By

Maiwada Zubairu

maiwadaz@yahoo.com

 

 

PREAMBLE

 

The recent announcement by the Nigerian Monetary Authorities on the increase of banks’ capital to N25 billion has received mixed  reactions with diverse set of perspectives with broad and competing views from finance and economics experts and non-experts. Some perceive the capital stance as a welcome development for it will align the Nigeria ’s banking sector with the international financial architecture- giving it adequate stability and international competitiveness.  Others perceive the policy stance as an antidote to broader macroeconomic disruptions in an environment characterized by various political and economic uncertainties, while others perceive the policy as an attempt to support certain political constituencies. To the “street economist” however, the capital stance of the monetary authorities is only a part of broader challenge- strengthening the safeguards against the frequent instability in the banking industry.

 

To detour a bit, it is pertinent to ask; why have banks been easy targets for economic reform? Why have they always been the object of particular concern to government, the economists and the public alike? Answers to these questions are quite complex. However, it is important to note that banks have always been at the forefront of economic development through out human history. Similarly, banks are back up sources of liquidity for all economic enterprises and serve as conduit through which government transmits and implements its monetary policies. Besides, the unique nature of banking business compels heavy reliance on short-term liabilities. As a highly leverage business, banking industry is quite prone to economic and political shocks. These and other reasons motivate government to once in while come up with policies, sometimes stringent, in order to ensure both micro and macro economic stability. The perceived stringent capital regulation is one such a policy.

 

This write-up will use “street economics” to add to the on going debate on bank capital and other prudential measures of ensuring banking and other financial system soundness and stability.

 

BANK CAPITAL: OVERVIEW AND SYNTHESIS

Financial experts tell us that bank capital consist of various elements that have varying availability and capability to absorb shocks – financial shock absorption, which as we shall see later, is one of the functions bank capital performs. First element of capital consists of permanent shareholders equity which they contribute to establish banking business and disclosed reserves – either mandatory or willing set asides from operating profit as business commences. The second element adds undisclosed reserves, asset revaluation premiums, loan loss reserves and long-term subordinated debt which individual banks could fit to source in the financial market. The third element adds short term subordinated debt. The aggregation of the three elements is the principal indicator of Capital Quality.

 

Capital quality not withstanding, bank capital is supposed to play the following roles:

  • It is supposed to limit moral hazards by putting bank owners money at risk  - thus the tendency to be risk averse.

 

  • In the event of economic slowdown, the bank capital could be a buffer against potential losses.

 

  • In the event of total bank failure, adequate capital may make banks easier to sell.

 

That said, varying economic, institutional and political environment affect how these roles are played. As argued below, there must be supplementary prudential regulations for the bank capital to play its proper roles. For instance, under the current arrangement, bank owners generate N2billion and open for banking business. Thanks to universal banking, they can do all kinds of financial business, deposit generation, asset generation (mostly loans) and other financial transaction such as securities and insurance market transactions. Just a scenario- with N2 billion, a bank can generate N 50 billion deposit and gives N 10 billion loan. Assuming the N2 billion is there intact, the share holders are exposing themselves to only 20% of the total risk, and the rest (80%) is passed to poor depositors.  Some of the loans go bad, and business as usual goes on year in year out – bad loan set asides accumulate and erodes the whole capital as well as the depositors’ funds. Where is the risk aversion? Where is the buffer? And who will buy the remaining liabilities? We have seen these happenings since Nigeria began financial sector liberalization in 1986. That was why some experts have been asking why N25 billion? Why not  N 30 billion, or N 50 billion or any other billion?

 

SUPPLEMENTARY PRUDENTIAL REGULATIONS

Capital stance alone can only go that far in ensuring banking stability – this is not to infer that the monetary authorities are not paying attention to other prudential regulations. Suffice is to point out that there are other necessary micro and macro prudential regulations that need to be given equal attention in order to ensure sound and stable banking system.

 

The micro prudential regulations should focus on the following individual bank’s indicators:

·         Safety indicators which include capital adequacy – the focus of this discourse, asset quality and credit concentration.

 

·         General performance indicators – trends in total assets, deposits and loans

·         Liquidity indicators- liquidity of assets, excess reserves and liquidity in domestic and foreign currency deposit liabilities.

 

·         Earning indicators – return on equity and return on assets

·         General Control indicator- loan/deposit ration and proportion of inter-bank lending.

 

The macro prudential regulations – which many experts believe would have better chance of securing financial stability, and thereby, making individual banking institution safer. These macro prudential regulations focus on the entire economy in which the banking system operates. Regulations that affect economic growth, balance of payments, inflation and interest and foreign exchange volatility will have far reaching influence on the overall financial stability.

 

POLICY IMPACT

The policy details on the new capital are not yet out. At the heat of the initial announcement, further clarification by the monetary authorities indicated that the N 25 billion include all the elements of capital mentioned previously. Financial experts call the aggregation of all the elements Share Holders Fund (SHF).

 

Any attempts to predict the impact of the new capital regulation will merely be crystal ball gazing. However with globalization of financial services there are lessons of experience. Anecdotal evidence from studies done by staff of World Bank and IMF suggests that the stringency of capital regulation is not very closely linked with banks’ performance or stability.  In fact some even suggest that higher capital requirement may induce users of funds to shift to security market and might even raise the cost of capital. The key concerns are whether minimum capital / asset ratio is in line with BASEL guidelines, whether the minimum ratio should vary as a function of market risk and what fraction of revaluation reserves will be allowed as part of capital adequacy ratio.

 

Given the “no going back” policy stance of the monetary authorities and in the absence of policy and incentive details, it is only realistic to at best sketch out the likely broad outcome of the capital policy rather than identify concrete policy impact. This is even truer when viewed against the fact that there are interrelationships of factors that affect banking system soundness and stability – which makes it difficult to analyze capital policy impact in isolation from other interrelated factors. A financial system with less than optimum institutional capacity and capability may likely witness:

  • Forced banking mergers with strange bed fellows serving a fragile economy.

  • A conglomerate  of few large banking entities who may:

ü       Have conflict of interest as result of diverse financial activities.

ü       Seize the opportunity of increased capital to take up more risk.

ü       Be difficult to monitor.

ü       Be economically and politically powerful to be disciplined.

ü       Be monopolistic enough to render competition and efficacy ineffective.

 

POLICY OPTIONS

“There is no theoretically optimal system or standard textbook blueprint for the structure and process of regulating and supervising financial institutions, including banks. In fact, arrangements for banking regulation and supervision differ considerably from country to country. Apart from differences in political structures, the most important factors that account for the differences in regulatory and supervisory approaches include the general complexity and state of development of the financial system, the number, size and concentration of banking institutions, the relative openness of the domestic financial system, the nature and extent of public disclosure of banks’ financial positions, and the availability of technological and human resources for regulation and supervision.” (Sahajwala and Bergh, 2000)

 

The above quoted experts’ statements clearly indicate that prudential regulations whether micro or macro are country and environmental specifics. No size fits all. Therefore the question then becomes which size fits which? Just as was indicated while discussing policy impacts, globalization of the financial sector gives us some lessons of experience to draw from.

  • World-wide, capital regulation is based on 1988 and refined in 1997 Bank of International Settlement requirement of 8% risk weighted capital/asset ratio- albeit with some variations. Such as higher requirements for economies that are vulnerable. The higher requirement was voluntarily adopted by Brazil which set the ratio at 32% with the policy reduction to 16% after 6 years of banks’ operation.

  • The British model of capital regulation addresses the second element of capital component first before addressing the first element. In which case it will enforce stringent policy on say loan-loss reserves and other components of the second element of the capital component.

 

If therefore we sympathize with the philosophy of “ No size fits all” regarding financial sector regulation policy, the monetary authorities can form “Hybrid” capital policy where:

  • There will be conformity with BASEL I or the upcoming BASEL II- setting the capital/asset ratio above the required level as was done in Brazil .

  • Different capital requirements are set based on size, ownership and level of risk exposure.

  • Banks will be compelled to go public over time – thus market price signals will indicate better operational disclosure.

But more importantly, there is urgent need for monetary authorities to work harder at establishing better institutional capacity and capability for effective banking regulation and supervision so as to reduce moral hazards and information asymmetry with regards to financial transactions in the country.

 

CONCLUSIONS

To conclude, it is important to note that comprehensive prudential regulation should encompass both the micro approach – individual banks and the macro approach- overall economic policies. Certainly we have not heard the last of financial and general economic policy changes. But the beauty of it all is that in a democracy, supposedly, both experts and “street economists” should have a voice on how they are being governed politically and more importantly economically.

Maiwada Zubairu

MD/CEO, KNOWLEDGE DYNAMICS LTD

P. O. BOX 11169 , KANO

 

 

 

 

 

 

 

 

 

 

 

REFERENCES

  1. Borio, C (2003) “Towards a macro prudential framework for financial supervision and regulation” BIS Working Paper No. 128.

 

  1. Bossone, B (2000), “ What makes banks special?” World Bank policy research working paper, No. 2408.

 

  1. IMF (2000) “Macro prudential indicators  of financial system soundness” Occasional paper No. 192

 

  1. James, R. B., Gerald, C., Ross, L (2001) “Banking supervision and regulation: What work best” World Bank policy research working paper, No. 2725

 

  1. Renhack, R (2000) “Banking supervision” Finance & Development 37, 1

 

  1. Sahajwala R, Berg, V. P. (2000) “Supervisory risk assessment and early warning system” Basel committee on banking supervision working paper No. 4.