BUILDING PUBLIC TRUST: CBN REFORMS AND FINANCIAL STABILITY
The world has come a long way since the evolution of the first chartered company in 1600, in England, and the first known corporate bubbles in 1720 which led to the South Sea bubbles Act (herein after SSBA). However, the repeal of the 1720 act in 1844 provides the bedrock of modern Anglo-Saxon corporate law.
The history of economic circles arguably, cannot be complete without the exposition and understanding of the first corporate failing in world history, which led to the SSBA above. More so, an insight into the economic depression of 1929 and subsequent market failures, merit in-depth study. Perhaps, the 21st Century world has grown beyond the barbaric act of executing a bank CEO in front of his bank as a result of the bank's insolvency, first witnessed in Spain.
Rather than allow barbarism to thrive, governments across the world decided to put in place laws, regulations, institutions' with requisite intellectual and human capital to discern, nip, regulate, and ensure that capital providers (investors) and depositors are effectively protected from potential insider or management abuses. Laws became the subset that drives economic exchanges in an efficient market. The mistrust that grew between capital providers, fund depositors', and management became common place, thereby requiring efficient monitoring and effective enforcement mechanism.
It would follow from the above, that economic circles have been here with us but nations have always dealt with the result of the cycles (crises) 'ex post', by laying down key prudential guidelines for future cycles 'ex ante', with the benefit of hindsight supposedly to forestall future crises. One would however, ask -what happened to the proactive treatment of possible failures? Were the regulators merely reactive or knew of impending market failures? What efforts were put in place to nip or immediately correct the possibilities of failures? Were the regulators captured?
Consequently, it is instructive to ask -why do regulators always treat symptoms instead of causes?
The centre piece of this essay is on financial stability and public trust. But, has the Central Bank of Nigeria, (hereinafter CBN) got it right? It is evident that the industrial age was financed by banks in most developed economies. Banks provided entrepreneurs and inventors with capital to develop their products whilst industrialization led to economic prosperity, increased GDP, and put employable people to work. Loans were given to those who would make optimal use of it. Industrialization arguably, led to social security, in most industrialized nations.
Invariably, the role of banks in economic development and world industrialization cannot be over emphasised. In the words of Paul A. Samuelson & William D. Nordhaus, [in Economics 488 (15th ed.1995)] '[no] institution has shaped economic development of the world more than the bank…from a macroeconomic vantage point the most important instrument is bank money…primarily provided today by commercial banks'
Perhaps, it would be right to state that before entrepreneurs transferred some portion of their wealth to others through the medium of capital market structure, banks bore the credit risk, industry risk, and debtors' exposure to the credit risk of their counter parties.
The latter is instructive because it is often over looked by modern banks in the internal treatment and evaluations of risk, prior to Basle 1&2 Convergence (but has Basle helped?). The stock market failures have made the banks wiser to factor in counter party exposure/s in future treatment of risk assessment, and to make adequate provisioning as prescribed in a given prudential guideline -in order to forestall the possibility of mis-match of deposits to withdrawals or debt to equity ratios.
Banks as medium for efficient allocation of economic resources
Arguably, for most banks, economic inputs for the survival of their institutions and other economic enterprises are provided by shareholders and savers/depositors; the latter contract with banks to earn interest on their deposits. Banks serve as intermediaries between savers and borrowers. Savers provide borrowers with economic input to generate economic output. Banks make their profits through interest rate spreads, between the rate they pay to depositors and the rate they lend to borrowers.
The basic assumption is that the above analogy is straight forward, and as such, since the interest of banks and depositors are closely aligned, the possibilities of inefficient allocation of depositors' and shareholders resources are eliminated. After all, the loans advanced by the banks are recorded as assets on their books, so they should take seriously the allocation of these assets by ensuring that the qualities of collaterals should provide sufficient cushion in the event of default by borrowers. But, this is farther from the truth, and has been contended to represent a text book theory. Agency cost and information asymmetries provide a different dimension to the whole analysis.
In contemporary society, there is a separation of ownership and control according to the seminal work by Adolf Berle and Means. A simple illustration is as follows; capital providers (investors) may not fully be in control of the day to day running (management) of the company, in a widely dispersed organisation. Also, the shareholders would have to contend with the divergence of interest, in a closely held company, whilst entrepreneurs hold majority of the shares, the minority shareholders are confronted with the same agency problems and information asymmetries as in widely dispersed corporations.
Accordingly, it can be argued that in no other institution is the management of divergence of interest more critical than in the banking sector. Management abuse and pursuit of self interested goals can lead to erosion of bank's capital with the potential risk of default in keeping to their obligations to depositors, creditors, and other financial institutions which might directly or indirectly (the latter example could be counter party risk) be exposed to a bank's insolvency. The contagion of failure could lead to systemic risk thereby threatening the entire financial system.
Since banking is about confidence and trust, ordinary examination of the possibilities of agency cost and the management of stakeholders' interests (corporate governance, hereinafter CG) in respect of the inherent conflicts that arise would have been nonexistent on the grounds of 'trust'. However, more and more issues now confront regulators, from traditional prudential regulations and management of systemic risk, to the abuses of corporate governance. The new challenge of liquidity risk is hereby illustrated below.
It is no longer a text book economics or mere academic exercise that liquidity risk is real; it has become a real challenge. The effect of Lehman Brothers on global financial system is a case in point, which led to the erosion of public trust and market confidence. This argument can be supported with the immediate withdrawal of US$ 43 Billion from Morgan Stanley on a single day after the collapse of Lehman Bros. Also, Bears Stearns saw the pool of its assets shrink by approximately 90% in three days. The result of Lehman's failure and the one day withdrawal above has provided regulators with another thing to worry about-liquidity risk. Liquidity squeeze became common place even in sophisticated and well developed markets.
The Nigeria Experience
There have been varied positions advanced by proponents and antagonist of CBN reforms. Some commentators and stakeholders often inquire the extent global recession impacted on Nigeria banking sector prior to and under Lamido Sanusi's leadership. Are there or were there cross border risk? And where there exposures as a result of the recession, or was it merely an excuse advanced by the affected banks and their CEOs?
Building Public Trust
There is no doubt that prior to Sanusi's appointment, public confidence in the banking sector was highly impaired- de-marketing by banks and the fear of possible insolvency became common place. Depositors' and shareholders' treated banks with suspicions, which led to high reputational risk, liquidity squeeze, and low interbank lending. The need to restore public confidence, ease liquidity squeeze, and encourage interbank lending became paramount. But, these needs could not be addressed without first correcting the ills that pervaded the market place. In order to earn (restore) public trust and market confidence, a system of checks and balances had to be put in place. The need for banks to act in line with acceptable international best practices, and the institutionalization of corporate governance principles became pertinent.
The days of anything goes had to be put to an end. Enforcement mechanism had to be flawless in dealing with various breaches by corporate insiders- who should have known better. Confidence was eroded and trusts betrayed, by those who owed us fiduciary duties. There were latent fears of systemic failures and potential risk of externalities, hence, the sacking of culpable bank CEOs. The antagonists of CBN reforms have criticized the sacking of the CEOs, but failed to advance a better cause of action in dealing with their infractions. They failed to address the issues of excessive exposure without adequate liquid assets to mitigate the exposures to any particular client or segment of the economy. They failed to address the quality of loans made by these CEOs, and the adequacy of collaterals provided as security, rather they engage in distractions and name calling.
The CBN Reforms under Sanusi Lamido Sanusi
In order to restore public trust, the governor, on assumption of office instituted a four dimensional approach in addressing the impending market failure. The need and urgency to strengthen financial regulation and supervision through enhanced disclosures requirements by financial institutions was paramount. Disclosure regime provides depositors and investors with necessary information to make timely and informed decisions, in evaluating the financial performance and soundness of a bank. The imperative of the regime has enthroned sound corporate governance, transparency, and reduced to some extent, information asymmetries, thereby putting market players on even ground with the equality of arms (information).
The return of confidence, trust, and availability of debt financing are indications that the Nigeria financial system has accepted the efficient business 'unusual' model under Lamido Sanusi. Today, we can make bold to say that in the CBN, there exist three undeniable integrities, namely: i. The process (regulations and banking supervision). ii. The institution (CBN) and iii.The person (the governor). The governor's policy directions, implementations, and the exercise of his enforcement powers in dealing with market failures further underscore the above assertion.
The CBN under Sanusi has taken proactive steps in ensuring that banks insolvencies and the potentials of systemic risk are nipped. The CBN has put in place dependable and enduring structures of checks and balances in order to forestall future failures. The approach to do things right and by the books would ensure that management take seriously the issues of risk; uphold sound corporate governance principles in line with best practices in the management of the divergent interest of stakeholders. And ensure that financial institutions embrace the culture of prudence.
In view of the above, it is therefore submitted that the future of predictable financial cycles have been built- that is, financial stability and the protection of all stakeholders' interest would remain paramount, while ensuring that laws would take precedence over men.