The Nigerian financial system has evolved over the last few decades, a series of peaks and troughs over time – the peaks signifying periods of quantum growth in business activity, asset size, revenues, risks, etc; the troughs signifying periods of acute systemic crisis. Empirical observation proves these have occurred as cycles over the years; hence the term “pro-cyclicality”. Pro-cyclicality is a series of accelerated economic activities that lead to eventual systemic financial crisis.
How does pro-cyclicality affect the supply of credits to the financial system?
There was a financial crisis between 2007 and 2009. Many world renowned financial institutions collapsed as a result of this. This also triggered the crisis in the Nigerian financial system in 2009. Foreign investors liquidated their hedge funds in Nigeria. The resultant effect was the stock market depreciating by about 70 percent leading to loan losses by banks due to margin lending. Their loan portfolio to oil and gas industry deteriorated dismally. Since Nigeria is an 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 increased their lending. Bank deposits and credits, tracking the price of oil, grew four-fold from 2004-2009 at an average of 76 percent per annum. Market capitalisation in the stock market also grew by 5.3 times while bank stocks appreciated by nine times within the same period. The capital market bubble was not commensurate with the growth in real sector indicators.
The bubble eventually burst. Oil prices crashed, leading to crystallised risks in the oil and gas sector. Companies that took credits from banks to finance importation of petroleum products had lost money to the fallen oil prices overnight. They began to default on their loans. Also, the foreign investors with hedge funds began to liquidate them, causing the stock prices to depreciate. Again, the corollary was further impairment to the loan books of margin loans to capital market players. At this point, Nigeria experienced one of the most severe systemic crises in its history. Eight Nigerian banks were announced by the CBN as insolvent and were taken over by 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 now in trickles. Banks are more risk-averse than ever. The real sector has been starved of adequate banking credits in the last six years. For self-sustained steady growth to occur, there must be optimal distribution of funding from the money sector to the real sector. In Nigeria, this has not been the case. Manufacturing companies and SMEs have had to cope with the exorbitant interest rates charged by the banks due to this. A cure to this malady may be the “Counter-cyclical Capital Buffer (CCB)”.
Counter-cyclicality is a variable moving in the opposite direction of the economic cycle. Therefore, the reduction in the supply of bank credits to the real sector as a result of systemic crisis is counter-cyclical.
The CCB 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. It requires CBN to monitor credit growth and other indicators that may signal a build-up of systemic-wide risk. Based on this assessment, the buffer will be put in place. The CCB as recommended by the Basel committee should range between 0 and 2.5 percent of common equity Tier 1 capital.
How does this buffer work? The volume of loans grows due to increased economic activity. However, if there is an economic downturn and the quality of the loan portfolio of banks begins to deteriorate, banks will be conservative in the issuing of new credits. The shortfall in the supply of credits will exacerbate the problem, deepening the crisis. The loans deteriorate further and the chain continues.
Therefore, the CCB protects the banking sector from losses resulting from periods of fluctuating economy and ensures that bank credits still remain available in this period.
CBN will monitor the growth of credits. 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 excessively, the CBN can mandate banks to increase the CCB as a contractionary measure. On the contrary, when the aggregate supply of credits is low due to pro-cyclical events, the CCB is reduced as an expansionary measure to ensure availability of credits.
The CBN can communicate these buffer decisions to banks so that their stakeholders can understand the rationale underpinning them. From implementation, the real sector can experience self-sustained steady growth throughout the economic cycle.
Dike Obi
