New Dawn For The Financial Sector—Bola Ahmed Tinubu

Now the markets and banks seem to be rebounding. Yet all is not as good as it appears. Much of the present gains are adduced from a different more subtle set of contrivances engineered by the former CBN governor. The vast differential in the official and parallel exchange rate has been nothing more than a bank bailout under another name. The roll-over of margin loans was necessary but without more, it is a trap. While shoring up the banks’ books by stealth, Soludo did nothing to change the rather unhealthy incentives that led the banks and investors toward the precipice in the first instance. Now that they believe a reprieve has been given, banks and investors are returning to the same speculative behaviour that almost crashed the system. If we allow this to continue, we may be looking at another substantial downturn within the near future.

Thus, the appointment of Governor Sanusi comes at an important juncture. It will be his task to rid the system of these flashy gimmicks that entice investors and fool the economy itself. Yet, he cannot be seen as trying too hard to stymie the financial and stock markets. He must also educate the public that the job of the CBN is not to simply applaud bigger banks and bigger profit statements by the banks. His core job is to ensure soundness and sustainability. Bigness without these things is a large building erected on a skimpy foundation. From what I know, Governor Sanusi is an able man. He is a wise choice for this position. I wish him the best. To a large degree, the fate of our economy rests in his hands.

How We Got There

The 2007-08 Nigerian financial bubble did what bubbles do — it burst. The tragedy is not that it exploded; once the bubble took shape, such an outcome was celestially ordained. The real grind was that the bubble was portrayed to Nigerians as a solid ground, as a profound achievement and not the errant gamble it really was. That we dawdle with things such as power generation and the Niger Delta crisis but yet rushed to partake in a gambit that could only end in disappointment is one of our nation’s dense inscrutabilities. But, this it seems, is how we act when confronted with a wholesome development on one hand and profiteering on the other. What we should embrace, we disdain. What we should rebuff, we enchain ourselves to as if we are bondsmen.

Nigeria does certain things with an urgency that is as breathtaking as it is curious. It took America several decades to shed its productive capacity and skew its economy to the point where the financial system had eclipsed the real sector in importance and political influence. It took from the 60s to the 90s for the financial sector to expand to where it could play the harmfully ambivalent role of both giving the real sector enough capital to exist but depriving it of what was needed to expand and renovate. As the American financial sector assumed such large proportions, it forgot its primary mandate was to feed the real sector. Instead, it dined on the capital intended for the productive sector in order to maintain its bloated corpus. The current financial crisis is the offspring of this disequilibrium. In America, this process took years. It was the result of economy processes left unregulated for too long.

Nigeria accomplished a similar feat in record time. What took America years to do as a by-product of the unmonitored grinding-down of its productive economy, we did in an instance by executive fiat. With the stroke of a pen, our financial system was redesigned to dominate, not facilitate the productive sector. With that one decision, we were consigned to live with the dual births of financial and stock market bubbles and to witness their twin deaths. A few years ago, most of us applauded the increased capitalisation requirements for banks as heralding a new prosperity. We correctly surmised a new era has opened. What we did not discern was that the prosperity foreshadowed was itself a shadow. Instead of looking at the reality of our financial and economic situation, we were encouraged to chase this shadow of shadows, convinced it would enrich us if we could just hold it. We chased. But as always when grasping after shadows, the image slipped through our fingers. In the end, we wound up tired and with empty hands.

It is instructive to learn from the American economic crisis. True, the intricacy and vastness of the American economy surpass ours. True, the peculiarities of the American financial crisis are distinct from ours. In America, initially exotic, now toxic, investment instruments such as credit debt swaps, collateralised debt obligations, special investment vehicles and derivative securities led unwitting investors to the almshouse and caused the near ruin of many once-strong financial houses. We have no such menu of financial instruments and sophisitcated financial markets. Despite these differences, the American and Nigerian declines have some important structural likenesses. First, America prided itself years ago as being the first nation to graduate from being an industrial power into becoming a post-industrial one. This progression brought more than America bargained for. Not all of it was salutary. America was to find the overall economic structure of the post-industrial society it had become as uncomfortably close to that of any pre-industrial society. America’s over-confident leap into the future turned out to be an unfortunate stumble into the past. The weaker a nation’s productive base, the harder it is to produce your way out of a downturn.

In recent years, both the American and Nigerian economies have been guilty of similar strategic sins. Their financial sectors and key players within these sectors grew too large for the health of the overall economy. With this, the role of these players became distorted. Banks should primarily be custodians of wealth. We all fall into jeopardy when they fail to create wealth. Banks make and handle paper. They do not make cars, harvest crops or build houses. The richest banks produce virtual wealth, not the real thing. In both America and Nigeria, capitalism yielded to financialism. In America, financialism arose out of capitalism. In Nigeria, financialism took hold even before true capitalism could take root. Thus, the current crisis does not trumpet the defeat of capitalism. Capitalism was defeated years ago. The current crisis demonstrates the bankruptcy of a system too heavily dependent on a heavy volume and velocity of financial transactions distinct and divorced from any productive sector endeavour. This message must not be construed as a diatribe against banks and bankers. When they play their rightful role, they are indispensable. However, they must recognise this limitation. When they do not, they are as dangerous to others and as self-destructive as a mine-layer with amnesia.

All we need to do is read history. In the decade prior to the Great Depression, the American financial sector exploded. The profits gained in this sector vatly eclipsed those of the real economy. Salaries of bank executives soared through the roof. Bankers went from being staid conservative guardians of the purse to become famboyant speculators who thought themselves too smart to fail. So giddy they became, they mistook their decisions to be sure money instead of the gambles they truly were. Investors saw the bankers’ success and were drawn to league with them. Everyone borrowed and margin loans piled higher than most mountains. Unbridled rent-seeking caused a steep climb of profits. The steep profits preceded and caused an even steeper decline. Sound familiar? The bankers of America’s past would recognise today’s Nigeria all too well.

Back then, America had to reignite its dormant productive capacity and create a new financial regulatory regime to pull itself from the dust of depression. In some ways, recovery today will be harder for America. Instead of restarting dormant industries as it did then, America must now invent new industries to replace those lost over the past three decades. It will have to reconfigure the financial system. The most logical and important aspect will be whether America decides to downsize its banks so that they no longer need to drain capital from the real sector to sustain themselves. By downsizing banks, America will turn them from their speculative tendencies toward facilitating the proper flow of capital to the productive sector. Nigeria should look closely at and take a few clues from the debate taking place in America.

It is simply inadequate to claim the financial system would have collapsed in the face of the global financial crisis but for the recapitalisation. That argument wastes words and shows a bankrupt logic. If this were the case, most banks in neighbouring countries should have gone bust. But the obverse is the case. The smaller banks in these nations have been less affected than Nigeria’s larger ones. No stock market on this continent has fallen so steeply during the same period and no stock market is so dominated by banks as this one. An even more important truth must not escape us. Blaming the decline of the banks and stock market on the global crisis is the equivalent of trying to cook food after eating it. The local decline began in March 2008, six months before the first signs of the global meltdown. Our economy could not have been affected by something that had not yet manifested. Thus, our downturn has peculiarly homegrown origins later exacerbated by the global sickness.

The structure of the banking system is at the core of Nigeria’s current financial difficulties. The crowning achievement of the CBN, bank capitalisation, has turned out to be a condemnable one. Forcing banks to capitalise to the higher levels skewed an already uneven relationship between the financial sector and the real sectors. The rapid acquisition of this level of capital had both quantitative and qualitative consequences, not all of which were positive. Because our officials were enamoured with the concept that bigger is automatically better they never undertook a critical analysis of what they were doing. They wanted to play in the big leagues and have the world take notice of bank size as if size automatically confers prowess. So bent were they on entering the upper stratum they forgot to weigh the costs of the excursion. However, even if you ignore them, costs will not ignore you. Sooner or later, they will dun you to pay their price.

The financial sector became too large for the underlying economy to support. Instead of being the mechanism allocating capital to real sector growth and employment, the financial system started to consume a larger chunk of the available capital to sustain its expanding self. The steep enlargement of the banks and thus of the entire banking sector within such a short period of time inevitably meant that growth of the banking sector would retard the real economy’s expansion. In the end, this policy of rapid, intense capitalisation of banks produced a systemic misallocation of capital. What transpired in the entire sector also happened within individual banks. For the individual banks, capitalisation was partly a cause. The banks were not ready for the gift hoisted upon them. The rapid accumulation of capital outstripped each bank’s ability to manage it. Internal structures and risk assessment capacity lagged behind the growth experienced. Despite the public bravado and confidence, the banks were disoriented.

They embarked in frenzied profit-making and other schemes to veil their internal panic and imbalances. To sustain profitability and attract money to quench their larger appetites, banks resorted to creative practices of questionable sustainability. The most egregious practices was the wanton use of margin loans to manufacture greater demand for bank stocks, inflating the values of those stocks. Margin loans assumed the sad role they had in the Great Depression. In a more up-to-date comparison, they became the local equivalent of the sub-prime mortgage-based securities America’s current financial leakage. By allowing banks to artificially inflate demand for their stocks, regulators assented to the further distortion of the balance between the real and financial sectors. The margin loan debacle shows that bank consolidation created a yawning regulatory gap within the government agencies tasked with monitoring the financial system and the stock market. Regulators were ill-prepared to force bank risk management and lending practices to a higher standard so that banks could handle the increased responsibility wrought by capitalisation.

Corrective Measures

The next step is to repair the damage. At the same time, we must lay the groundwork for a stable financial system that generates the proper set of incentives. This means a framework where players are not encouraged to act like profiteers gaming the system but to be prudent investors seeking good profit within the context of economic growth-oriented more toward the real sector than the financial.

Five major steps needed to be taken to accomplish this:

• Downsize the number of existing banks so that none are too strategically important.

•Differentiate between traditional banking and investment banking

•Enact a better regulatory regime that places limits on margin loans, short selling and aggregate debt.

• Implement policies that encourage banks to lend to critical industries

•Reduce the differential between the official and parallel market exchange rates.

Downsizing, Differentiation and Debt

One thing Nigeria must do is to use this crisis to trigger banking reform. To do so, we must exorcise the maxim that bigger is better. The crisis teaches us the creation of banks larger than warranted by the underlying economic fundamentals is a sure path to financial overheating and its unsettling consequences. The United States had to relearn this lesson. Now in search of financial sobriety after years of reckless financial engineering, a policy of downsizing financial institutions is gaining credence in Washington. Reform in Nigeria should follow suit. In no way should reform aim for even bigger banks. To do so, would predestine another financial bubble and its resultant breakdown. The only item cleft for conjecture would be the exact date of the collapse, not its likelihood. Going bigger is the equivalent of going blind to the facts before our eyes.

Bigger firms would be compelled to scour the landscape, greedily eating scarce capital better utilised in the service of the productive sector. Moreover, the firms would have to engage in too many speculative financial transactions to attract investors and keep shareholders happy. Generally, such transactions create handsome profits. The problem is that the profits are not only recorded on paper, they consist only of paper. They do not result in any increased quantity goods or valuable service by which real wealth is measured. For a moment, the statistics would look wonderful. However, reality comes to knock the door at the hour least expected. An economy cannot be built on accounting wizardry anymore than a castle can be built on a cloud.

Margin Loans And Enhanced Regulation

The new CBN Governor must quickly ascertain the aggregate value of these loans and gauge the vulnerability of the system based on that aggregate value. Then he must also “street test” each bank with large portfolios of significant overdue loans. He must establish a clear mechanism to cleanse these loans from the system. Continued roll-over just prolongs and sharpens the eventually reckoning. He must develop a mechanism that requires banks to sell or write down these bad loans depending on the health of the bank. Under such a plan, government can be a buyer of last resort or can guarantee purchases of the loans, thus preventing the banks from bearing complete losses. Additionally, financial regulators should pay much closer attention to aggregate debt levels. This current global crisis teaches us that debt levels beyond a certain point imply speculation, dislocation of capital, and an eventual downturn. The greater the debt, the greater a proportion of it will be dishonored. Regulators need to do much better in making sure debt stays within reasonable limits so as to curtail reckless lending and thus retain a high level of confidence in the banking sector.

Stock Market

Be glad that the stock market has seen gains in recent weeks but do not take too much solace in this. The health of the stock market is tied to the banks, as long as the banks represent two-thirds of the market’s capitalisation. More importantly, the market probably over-corrected itself downward over the past few months. This is just a mild upward correction. It will not return the market to the dizzying heights experienced last year. Nor should it. Those record levels were the product of speculative exuberance. To return to that height would require a return to heedlessness. The sober truth is that the fundamentals underlying the economy as a whole do not warrant the great appreciation of the stock market beyond current levels. If the market climbs too fast, too soon, it will be the sign that an even steeper decline waits in the offing. Stock market regulators failed us these past few years. Had they performed according to their job description and not their self interests, the warning would have been sounded before the fire burnt everyone’s profits. The stock market requires substantial reform. First, insider trading needs to be curtailed. Second, those who have official positions on the stock exchange should not be active players in the market. This is a clear conflict of interest. Self-regulation does not work. It quickly reduces itself to self-enrichment.

Third, a moratorium needs to be imposed on the introduction of derivative securities and other exotic instruments. Our regulators showed ineptitude in monitoring margin loans. Derivatives are infinitely more complex. They are not well understood and were abused in the more established exchanges in New York, London and Tokyo. They are at the bottom of this global downturn. To invite derivatives into this environment is to invite a disaster from which a few will benefit but most will regret. Those who advocate this introduction are seeking ways to maximise their short-term profits at the expense of the overall economy and less agile investors.

Promote Growth Industries

Government needs to work more closely with the banks to promote the industries that form the critical path of Nigeria’s growth and development. This would first require a well-designed national industrial policy. As part of that policy, government would work with the banking sector to devise favourable financial mechanisms to encourage investment in those enterprises that will grow Nigeria and tackle unemployment. Loans with favourable interests rated backed by government guarantees would be one tool in this arsenal.

End The Exchange Rate Differential

The exchange rate differential is an economic bane to most but a financial boom to some. For those in the banking sector, it represents a bank bail-out by stealth, a hand-out being done through the side window. The large differential encourages banks to round-trip money. This assured rent-seeking has helped restore their balance sheets depleted by last year’s meltdown. However, the differential is a curse to the productive sector for it constitutes a most insidious form of taxation. First, because of the enormous guaranteed profits get from simply playing the differential, banks are loathe to lend to long-term investments that cannot possible rival the returns that exchange rate manipulation brings. Thus, businessmen must pay a higher cost to borrow than they ought. Second, business operations are caught between a rock and a hard place. Firms must pay the higher rate when they purchase goods, especially imports. However, when converting their revenue, these firms are reduced to the official rates. Even when they can convert at the higher end, it is never at the same rate they buy goods and too much time is spent in currency conversion to the detriment of productive activity.

Conclusion

Nigeria must not simply try to weather the downturn in order to return to business as usual. That would simply portend another boom and bust cycle. Nigeria must learn lessons from the current crisis to reform the financial system from the speculative mechanism it has become to being the facilitator of true economic growth that all Nigerians need.