The Nigerian financial system presently in its adolescent stage, has evolved over the last few decades. This evolution is characterised by a series of peaks and troughs over time. The peaks signifying periods of quantum growth in business activity, asset size, revenues, risks and various other indicators. The troughs signifying periods of acute systemic crisis. Empirical observation has shown that these have occurred as cycles over the years; hence the term – “Pro-cyclicality”. Pro-cyclicality refers to any form of stimulus or economic activity that can cause fluctuations in the financial system. According to the Bank for International Settlements (BIS):
The term “pro-cyclicality” is generally used to refer to the mutually reinforcing (“positive feedback”) mechanisms through which the financial system can amplify business fluctuations and possibly cause or exacerbate financial instability. These feedback mechanisms are disruptive and apparent during an economic downturn or when the financial system is facing strains…”
This article intends to specifically elucidate pro-cyclicality in the supply of credits to the financial system.
The world economy was hit by an unprecedented financial crisis between 2007 and 2009 in which the sub-prime crisis aggravated the recessionary trend. Many world renowned financial institutions collapsed as a result of this. These global events also triggered the financial crisis in the Nigerian financial system in 2009. Most foreign investors began to liquidate their hedge funds in Nigeria. The resultant effect was the stock market depreciating by about 70% leading to loan losses by banks due to margin lending. The global slide in oil prices worsened the situation by making banks to swim against the tide – their loan portfolio to oil and gas industry deteriorated dismally. With Nigeria being a majorly oil dependent economy, the banking sector activities closely mirrored the price of oil and its volatility. When the oil prices were leaping in a bullish manner, and amounts of deposits in the banking sector increased due to the increment in oil revenue, banks were able to increase their lending. According to the Central Bank of Nigeria, “bank deposits and credits, tracking the price of oil, grew four-fold from 2004-2009 at an average of 76% per annum”. Market capitalisation in the stock market also grew by 5.3 times while bank stocks appreciated by 9 times within the same period. The capital market bubble was not commensurate with the growth in real sector indicators.
However, the bubble eventually burst. Oil prices crashed, leading to crystallised market risks in the downstream oil and gas sector. Companies that had taken loans from banks to finance the importation of petroleum products had lost money to the fallen oil prices overnight. They began to default on their loans. The Counterparty Credit Risks (CCR) in banks portfolios began to crystallise. Also, the foreign investors with hedge funds embedded in the Nigerian financial system began to liquidate them, causing the stock prices to depreciate. Again, the corollary was further impairment to the loan books of banks that had issued margin loans to capital market players. At this point, the music was over. Nigeria experienced one of the most severe systemic crises in its history. 8 Nigerian banks were announced by the CBN as insolvent. Their management was replaced and their delinquent assets were bought over by the Asset Management Corporation of Nigeria (AMCON).
Subsequently, the nozzle for disbursement of credits has been constricted in the Nigerian financial system. Due to liquidity squeeze and tightened credit guidelines by the regulators, the supply of credits to the real sector today is no longer torrential but in trickles. Banks are more risk averse than ever. It is an unequivocal fact that as a result of the last systemic crisis, the real sector has been starved of adequate banking credits in the last 6 years. This is obviously inimical to economic development.
For self-sustained steady growth to occur, the real sector must shadow the money sector. There must be optimal distribution of funding from the money sector to the real sector. The financial system must be structured in such a way that the activities of the real sector are financed by the money sector. In Nigeria, of recent years, this has not been the case; especially since the last systemic crisis in the financial system took place. The implication of this is that the real sector has been starved of necessary supply of credits for its survival. Manufacturing companies and SME’s have had to cope with the exorbitant interest rates charged by the banks due to insufficient supply of credits to the system. A cure to this malady which I will discuss on this article is if the Central Bank introduces what is called the “Counter-cyclical Capital Buffer”.
As against pro-cyclicality, counter-cyclicality is the other way round – an economic variable goes in the opposite direction as a result of the change in direction of the other i.e. moving in the opposite direction of the economic cycle. Therefore in this context, the reduction in the supply of bank credits to the real sector as a result of systemic crisis is counter-cyclical.
The counter-cyclical Capital Buffer is a cushion that has been introduced by the Basel Committee on Banking Supervision (BCBS) to prevent the amplification of counter-cyclical effects of systemic crisis in the banking sector. In section IV of the Basel III document (BCBS 2010b) and in the guidance document (BCBS 2010c), it requires national authorities to monitor credit growth and other indicators that may signal a build-up of systemic-wide risk. Based on this, assessment, a counter-cyclical capital buffer will be put in place. The Counter-cyclical Capital Buffer as recommended by the Basel committee should range between 0 and 2.5% of common equity Tier 1 capital for a banking financial institution.
How does this buffer work? The volume of loans grows due to increased economic activity. However if asset prices bubbles burst or there is an economic downturn and the quality of the loan portfolio of banks begins to deteriorate, banks will naturally be more conservative in the issuing of new credits. The shortfall in the supply of credits will in turn further exacerbate the problem, pushing the economy into deeper crisis with asset prices declining further. The non-performing loans also deteriorate further and the chain continues. Therefore, the Counter-cyclical Capital Buffer does the following in this scenario:
i. Protects the banking sector from losses resulting from periods of excessive credit growth followed by periods of stress; this is the achievement of the broader macro-prudential objective
ii. Ensures that bank credits still remain available in this period.
In the build-up phase, as bank credits are growing at a rapid rate, the Counter-cyclical Capital Buffer may cause the cost of credits to increase; thereby acting as a brake on bank lending. The national authorities in each jurisdiction (CBN in this case) will monitor the growth of credits using tools like the aggregate private sector Credit-To-GDP ratio as a trend and arriving at the “credit gap” (however, this tool is not sacrosanct but serves as a guide). In doing this, it can easily detect imbalances in the supply of credits in relation to the level of economic output.
When credits are growing at an excessive rate in the economy, the CBN can mandate banks to increase the CCB as a contractionary measure to aggregate bank lending. On the contrary, when the aggregate supply of credits is low due to pro-cyclical events, the CCB is reduced as an e
xpansionary measure to ensure the availability of credits even at this phase.
The CBN can also communicate these buffer decisions to banks so that their stakeholders can understand the rationale underpinning them. The implementation of the CCB is most likely a guarantee that credit crunch situations in the financial system would be averted even during systemic crisis. In this way, the real sector can experience self-sustained and steady growth throughout the economic cycle. Credits to the real sector can then be readily available, hence, economic growth and development.