Rethinking Regulation for Financial System Stability in Africa

Published on 8th June 2009

Perhaps because of the sheer size of the American financial system, once the Glass Steagall obstruction was eliminated, it quickly established itself as the champion of the transition from a bank based system of financial intermediation to a credit market based system. Under the new system, the practice of securitization of assets reigned supreme. Problem assets were simply securitized through complex models and transferred to third parties with the aid of Special Purpose Vehicles (SUVs). This effectively removed such assets from the balance sheet of the financial institutions that originated them. This was the very foundation of the US subprime mortgages which is at the centre of the current financial crisis.  

 

A key instrument that has helped promote the various complex financial products that have emerged from securitization is the evaluation provided on such products by rating agencies. This is because the acceptance of such products, until recently, had been based on the ability of such institutions to convince the markets about the viability and profitability of the securitized financial products. This has been mostly achieved through obtaining the endorsement of rating agencies. An apt example of the mechanics and possible structural defects in the ratings process has been documented as follows:

 

A mortgage trust assembled by a prominent investment bank had a portfolio of second mortgage loans that had essentially no borrower equity and had little or no documentation on more than half the loans. Amazingly, 93 percent of the tranches were rated investment grade by the two main credit rating agencies. As of September, 18 percent of the loans had defaulted wiping out many of the lower-rated tranches. 

 

Thankfully, there is now widespread consensus that the current structure and process of rating is fundamentally flawed and in need of urgent reform.

 

Another factor that helped fuel the above developments was the inappropriate mechanism for remunerating staff of financial institutions. Arguably guided by neo liberal economic principles, an unhealthy culture of excessive pay and bonuses have developed over time in the industry. These inappropriate incentive structures no doubt played some role in encouraging behavior which contributed to the crisis.     

 

The change from a bank based system of financial intermediation to a market based system also created structural problems for bank regulators. This is because the securities sector has traditionally not been as policed as the banking sector. The emergent scenario encouraged regulatory arbitrage allowing banks to hide their activities using off balance sheet legal entities and complex derivatives.  The consequence of the above was that the existing regulation failed to keep pace with the changes in the financial system. The insurance of bank deposits became ineffective as it inadvertently meant open ended support for banks’ securities businesses.

 

Interestingly, the International Monetary Fund as recently as 2006 had declared the entire concept of securitization a positive development that could strengthen the financial system. According to the IMF:

 

There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient. Over the last decade, new investors have entered the credit markets, including the credit risk transfer markets. These new participants, with differing risk management and investment objectives (including other banks seeking portfolio diversification), help to mitigate and absorb shocks to the financial system, which in the past affected primarily a few systemically important financial intermediaries. The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently, the commercial banks, a core segment of the financial system, may be less vulnerable today to credit or economic shocks.

 

The current global financial crisis has however proved the above optimism to be poorly founded. Complexities in the financial system have helped ensure that such securitised assets, rather than being dispersed to various end investors, ended up in the books of highly leveraged banks and bank like institutions.

 

Based on the above, it is not surprising that it is the financial systems of the developed countries that have adopted Anglo-American style financial systems which stress the role of markets in corporate finance that have been most affected by the current financial crisis. With technological developments, unrestricted capital flows and increasing globalisation of financial businesses, some of the securitised subprime American loans have ended up in the books of banks in such developed countries.

 

The financial crisis in these developed countries has however snowballed into a global economic crisis and recession. It is this global recession, rather than the subprime mortgage crisis that has caused damage to the financial system of countries with inconvertible currencies and exchange control restrictions. In other words, financial sector induced recession in some of the world’s biggest economies have led to economic crisis in several developing countries. Specifically, this has resulted in declining commodity prices, investments, credit and exports. The above has consequently created problems for the financial system in such developing countries. Most African countries fall under this category. A review of the African financial architecture and regulation is therefore welcome at this stage. In the first instance, it will enable us address the financial stability issues that have been exposed, directly and indirectly, by the current global financial and economic crisis. 

 

Arguably more important however is the fact that this also provides us with a unique opportunity to think about the continental regulatory challenges that are bound to emerge given the changing landscape of the African financial system which unlike the global economic crisis is being induced from within the continent.

 

Next week: The Changing Financial System Landscape in Africa  

 

By  Chibuike U Uche

Alexander von Humboldt Georg Forster Fellow, Institute for Asian and African Studies,Humboldt  University, Berlin   

and  

Professor of Banking and Financial Institutions, University of Nigeria,

Enugu Campus,  NIGERIA.

 

Presented at the international conference on Central Banking, Financial Stability and Growth, organised by the Central Bank of Nigeria to commemorate fifty years of central banking in Nigeria


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