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Anatomy of a systemic banking crisis

September 21, 2009

According to a Lessons from Systemic Bank Restructuring, an Economic Issues paper by the International Monetary Fund (IMF) “In recent decades, many countries have experienced banking problems requiring a major – and expensive – overhaul of their banking systems.”

The paper analysed “the experiences of 24 countries [from all areas of the world] that initiated reforms in the 1980s and early 1990s: 4 industrial and 15 developing countries, and 5 countries in transition to market-oriented systems.” According to the authors “a banking crisis [is] systemic if a fifth or more of the total deposits in the national system was affected.”

Combinations of causes are responsible for a systemic banking crisis. These range from, internal: weak supervision and inadequate capital, and external: falling oil prices and erosion of assets. Once ignited such a crisis has necessitated broad reforms.

Ostensibly, reforms are better executed during a time of calm; hence the recapitalisation and consolidation of Nigerian banks in 2004. But it seems salient aspects of Nigeria’s banking consolidation, risk management and corporate governance, were paid little attention. Besides, initial efforts to stem the tide, following the global economic crisis, were shoddily executed. Last week’s sweeping changes averted a systemic risk.

If one bank had failed there would be no national repercussion. But if a large proportion fails: depositors, lenders and shareholders all lose confidence; consequently paralysing the economy. The only option: government action however difficult and costly the remedies.

Systemic restructuring: what, how and who?

Whatever the remedies, there were different approaches and degrees of success – each with lessons to be learnt by comparing strategies, policies and tools. To the authors, systemic bank restructuring is “to improve bank performance – that is, restore solvency (net worth) and profitability, improve the banking system’s capacity to provide financial intermediation between savers and borrowers, and restore public confidence.”

Specifically, it involves restructuring bank balance sheets by injecting fresh capital (from existing or new owners or from the government), reduction of liabilities (writing down the value of certain debts eg, margin loans). Operational restructuring measures affect profitability eg, better credit assessment and approval techniques. All with the awareness that the banking system’s capacity for intermediation rests on improved supervision and prudential regulation.

The paper considered two aspects of banking performance: solvency and sustainable profitability. The ratio of nonperforming loans to total loans and ratio of capital to assets were used to assess bank solvency. Bank profitability was assessed by the ratio of operating expenses to assets, ratio of interest income to assets and the ratio of profits to assets.

Six indicators: the ratio of the growth of credit to the private sector to GDP growth; the ratio of broad money to GDP; changes in interest spreads; central bank credit to banks as a percentage of GDP; changes in the real interest rate; and experiences with recurrent banking problems were used to measure the improvement of the financial intermediation capacity of the banking system.

Though individual country’s systemic bank restructuring differ, prompt corrective action was regarded as “a key ingredient of successful banking reform.” Likewise, countries that made progress were characterised by accurate diagnosis (nature and extent of causes); swift response (within one year of the problem’s emergence), and systematic and comprehensive reform. Also, countries that made good progress were those that “sudden outside events, like the collapse of export prices or soaring world interest rates, often triggered the banking crises, forcing the countries to undertake comprehensive reform.”

Solvent today, illiquid tomorrow

The authors further highlighted that solvency is just the first step. Long-term, a successful reform shuns complacency. It goes beyond restoring solvency, which is quick and relatively easy. Restoration of profitability is more tedious. Operational restructuring, the key to profitability, is more difficult and time-consuming. It requires management changes (deficient management was common to all 24 countries studied), reduction of operating costs, stronger accounting, legal and regulatory systems backed by “firm and consistent supervision and compliance” were listed as touchstones of successful banking reforms.

What was the role of the respective central banks in restructuring? This role depends on accurate diagnosis of the problem from the onset. A supportive rather than lead role, by the central bank, was considered the better option. That is, non-involvement in operational matters. Otherwise, the central bank “gets drawn into financing bank restructuring measures, exceeding its resources, and taking actions that conflict with its basic responsibilities for monetary management.” The alternative is the designation of a lead agency with responsibility to monitor restructuring policies and individual bank restructuring operations if necessary. How the loss is shared also matters.

Nigeria’s response: what next?

From all indications, the Nigerian government has implicitly guaranteed depositors, shareholders and creditors – no bank is expected to fail.  Still, ring-fencing nonperforming loans and transferring them to a separate loan agency was considered an effective way of sorting out solvency problems. This action improved banks’ balance sheets and allowed them to focus on their core business – it however didn’t solve the problem of low profitability. Though the presidency has assured that no banks will be allowed to fail; a clear policy on what a viable bank consists of will permit easy disposal of failed banks if necessary.

In all, the Central Bank of Nigeria’s timing was deft – a combination of communication and co-ordination. Announcements to recapitalise five banks and change the top management was made on Friday 14th August to prevent turbulence in the stockmarket come Monday August 17th.  Prompt replacement of management with the directive to run the bank as going concerns will help stem uncertainty. Temporary suspension of the shares these banks from the trading floor is likely linked to plans to disclose the identity of owners.

Yet there are questions. Can CBN sustain the cleansing, assuming there are other banks? $2.6 billion has been pumped in with 14 more banks yet to be audited. From estimates, 600 billion naira more may be required for the rot to be totally tamped. Does the government have the money? Will it have to print more and run the risk of stoking inflation which is dipping?

Also, does the CBN have a blank cheque or will it need legislative approval to pump in more money? Likewise are there plans to fast track the establishment of the Asset Management Company (a “bad bank” to house toxic assets on bank balance sheets?) Hopefully, the nomination of Dr Kingsley Moghalu, as deputy governor, other board and Monetary Policy Committee members will add energy to the CBN’s risk management credentials.

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