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The state of the global financial system: A decade after the crisis

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It all originated with debt! In the early 2000s, US real estate seemed irresistible, and a heady run-up in prices led consumers, banks, and investors alike to load up on debt. Exotic financial instruments designed to diffuse the risks instead magnified and obscured them as they attracted investors from around the globe.

Cracks appeared in 2007 when US home prices began to decline, eventually causing the collapse of two large hedge funds loaded up with subprime mortgage securities. Yet as the summer of 2008 waned, few imagined that Lehman Brothers was about to go under—let alone that it would set off a global liquidity crisis. The damage ultimately set off the first global recession since World War II and planted the seeds of a sovereign debt crisis in the Eurozone. Millions of households lost their jobs, their homes, and their savings.

The road to recovery has been a long one since those white-knuckle days of September 2008. Historically, it has taken an average of eight years to recover from debt crises, a pattern that held true in this case. The world economy has recently returned to robust growth, although the past decade of anemic and uneven growth speaks to the magnitude of the fallout.

Central banks, regulators, and policy makers were forced to take extraordinary measures after the 2008 crisis. As a result, banks are more highly capitalized today, and less money is sloshing around the global financial system. But some familiar risks are creeping back, and new ones have emerged.

Below are the findings on the financial markets and how the landscape has changed.

  1. Global debt continues to grow, fueled by new borrowers
  2. Households have reduced debt, but many are far from financially well
  3. Banks are safer but less profitable
  4. The global financial system is less interconnected—and less vulnerable to contagion
  5. New risks bear watching

 

Global Debt Continues to Grow, Fueled by New Borrowers

As the Great Recession receded, many expected to see a wave of deleveraging. But it never came. Confounding expectations, the combined global debt of governments, nonfinancial corporations, and households has grown by $72 trillion since the end of 2007. The increase is smaller but still pronounced when measured relative to GDP.

Underneath that headline number are important differences in who has borrowed and the sources and types of debt outstanding. Governments in advanced economies have borrowed heavily, as have nonfinancial companies around the world. China alone accounts for more than one-third of global debt growth since the crisis. Its total debt has increased by more than five times over the past decade to reach $29.6 trillion by mid-2017. Its debt has gone from 145 percent of GDP in 2007, in line with other developing countries, to 256 percent in 2017. This puts China’s debt on par with that of advanced economies.

Growing government debt

Public debt was mounting in many advanced economies even before 2008, and it swelled even further as the Great Recession caused a drop in tax revenues and a rise in social-welfare payments. Some countries, including China and the United States, enacted fiscal-stimulus packages, and some recapitalized their banks and critical industries. Consistent with history, a debt crisis that began in the private sector shifted to governments in the aftermath. From 2008 to mid-2017, global government debt more than doubled, reaching $60 trillion.

Among Organization for Economic Cooperation and Development countries, government debt now exceeds annual GDP in Japan, Greece, Italy, Portugal, Belgium, France, Spain, and the United Kingdom. Rumblings of potential sovereign defaults and anti-EU political movements have periodically strained the Eurozone. High levels of government debt set the stage for pitched battles over spending priorities well into the future.

In emerging economies, growing sovereign debt reflects the sheer scale of the investment needed to industrialize and urbanize, although some countries are also funding large public administrations and inefficient state-owned enterprises. Even so, public debt across all emerging economies is more modest, at 46 percent of GDP on average compared with 105 percent in advanced economies. Yet there are pockets of concern.

Countries including Argentina, Ghana, Indonesia, Pakistan, Ukraine, and Turkey have recently come under pressure as the combination of large debts in foreign currencies and weakening local currencies becomes harder to sustain. The International Monetary Fund assesses that about 40 percent of low-income countries in sub-Saharan Africa are already in debt distress or at high risk of slipping into it. Sri Lanka recently ceded control of the port of Hambantota to China Harbor Engineering, a large state-owned enterprise, after falling into arrears on the loan used to build the port.

 

Corporate borrowing in the era of ultra-low interest rates

An extended period of historically low interest rates has enabled companies around the world to take on cheap debt. Global nonfinancial corporate debt, including bonds and loans, has more than doubled over the past decade to hit $66 trillion in mid-2017. This nearly matches the increase in government debt over the same period.

In a departure from the past, two-thirds of the growth in corporate debt has come from developing countries. This poses a potential risk, particularly when that debt is in foreign currencies. Turkey’s corporate debt has doubled in the past ten years, with many loans denominated in US dollars. Chile and Vietnam have also seen large increases in corporate borrowing.

China has been the biggest driver of this growth. From 2007 to 2017, Chinese companies added $15 trillion in debt. At 163 percent of GDP, China now has one of the highest corporate-debt ratios in the world. It is estimated that roughly a third of China’s corporate debt is related to the booming construction and real-estate sectors.

Companies in advanced economies have borrowed more as well. Although these economies are rebalancing away from manufacturing and capital-intensive industries toward more asset-light sectors, such as health, education, technology, and media, their economic systems appear to run on ever-larger amounts of debt.

In another shift, corporate lending from banks has been nearly flat since the crisis, while corporate bond issuance has soared (Exhibit 2).

The diversification of corporate funding should improve financial stability, and it reflects deepening capital markets around the world. Nonbank lenders, including private-equity funds and hedge funds, have also become major sources of credit as banks have repaired their balance sheets.

 

Households have Reduced Debt, but many are far from Financially Well

Unsustainable household debt in advanced economies was at the core of the 2008 financial crisis. It also made the subsequent recession deeper, since households were forced to reduce consumption to pay down debt.

 

Mortgage debt

Before the crisis, rapidly rising home prices, low interest rates, and lax underwriting standards encouraged millions of Americans to take out bigger mortgages they could safely afford. From 2000 to 2007, US household debt relative to GDP rose by 28 percentage points.

Housing bubbles were not confined to the United States. Several European countries experienced similar run-ups—and similar growth in household debt. In the United Kingdom, for instance, household debt rose by 30 percentage points from 2000 to reach 93 percent of GDP. Irish household debt climbed even higher.

US home prices eventually plunged back to earth starting in 2007, leaving many homeowners with mortgages that exceeded the reduced value of their homes and could not be refinanced. Defaults rose to a peak of more than 11 percent of all mortgages in 2010. The US housing collapse was soon mirrored in the most overheated European markets.

Having slogged through a painful period of repayment, foreclosures, and tighter standards for new lending, US households have reduced their debt by 19 percentage points of GDP over the past decade (Exhibit 3).

But the homeownership rate has dropped from its 2007 high of 68 percent to 64 percent in 2018—and while mortgage debt has remained relatively flat, student debt and auto loans are up sharply.

Household debt is similarly down in the European countries at the core of the crisis. Irish households saw the most dramatic growth in debt but also the most dramatic decline as a share of GDP.

The share of mortgages in arrears rose dramatically when home prices fell, but Ireland instituted a large-scale mortgage-restructuring program for households that were unable to meet their payments, and net new lending to households was negative for many years after the crisis.

Spain’s household debt has been lowered by 21 percentage points of GDP from its peak in 2009—a drop achieved through repayments and sharp cuts in new lending. In the United Kingdom, household debt has drifted downward by just nine percentage points of GDP over the same period.

In countries such as Australia, Canada, Switzerland, and South Korea, household debt is now substantially higher than it was prior to the crisis. Canada, which weathered the 2008 turmoil relatively well, has had a real-estate bubble of its own in recent years. Home prices have risen sharply in its major cities, and adjustable mortgages expose home buyers to rising interest rates. Today, household debt as a share of GDP is higher in Canada than it was in the United States in 2007.

 

Other types of household debt

Looking beyond mortgage debt, broader measures of household financial wellness remain worrying. In the United States, 40 percent of adults surveyed by the Federal Reserve System said they would struggle to cover an unexpected expense of $400. One-quarter of nonretired adults have no pension or retirement savings.

Outstanding student loans now top $1.4 trillion, exceeding credit-card debt—and unlike nearly all other forms of debt, they cannot be discharged in bankruptcy. This cycle seems likely to continue, as workers increasingly need to upgrade their skills to remain relevant. Auto loans (including subprime auto loans) have also grown rapidly in the United States. Although overall household indebtedness is lower since the crisis, many households will be vulnerable in future downturns.

 

Banks are Safer but Less Profitable

After the crisis, policy makers and regulators worldwide took steps to strengthen banks against future shocks. The Tier 1 capital ratio has risen from less than 4 percent on average for US and European banks in 2007 to more than 15 percent in 2017. The largest systemically important financial institutions must hold an additional capital buffer, and all banks now hold a minimum amount of liquid assets.

 

Scaled back risk and returns

In the past decade, most of the largest global banks have reduced the scale and scope of their trading activities (including proprietary trading for their own accounts), thereby lessening exposure to risk. But many banks based in advanced economies have not found profitable new business models in an era of ultra-low interest rates and new regulatory regimes.

Return on equity (ROE) for banks in advanced economies has fallen by more than half since the crisis (Exhibit 4).

The pressure has been greatest for European banks. Their average ROE over the past five years stood at 4.4 percent, compared with 7.9 percent for US banks.

Investors have a dim view of growth prospects, valuing banks at only slightly above the book value of their assets. Prior to the crisis, the price-to-book ratio of banks in advanced economies was at or just under 2.0, reflecting expectations of strong growth. But in every year since 2008, most advanced economy banks have had average price-to-book ratios of less than one (including 75 percent of EU banks, 62 percent of Japanese banks, and 86 percent of UK banks).

In some emerging economies, nonperforming loans are a drag on the banking system. In India, more than 9 percent of all loans are nonperforming. Turkey’s recent currency depreciation could cause defaults to climb.

The best-performing banks in the post-crisis era are those that have dramatically cut operational costs even while building up risk-management and compliance staff. In general, US banks have made sharper cuts than those in Europe. But banking could become a commoditized, low-margin business unless the industry revitalizes revenue growth. From 2012 to 2017, the industry’s annual global revenue growth averaged only 2.4 percent, considerably down from 12.3 percent in the heady pre-crisis days.

 

Digital disruptions

Traditional banks, like incumbents in every other sector, are being challenged by new digital players. Platform companies such as Alibaba, Amazon, Facebook, and Tencent threaten to take some business lines, a story that is already playing out in mobile and digital payments.

It is projected that as interest rates recover and other tailwinds come into play, the banking industry’s ROE could reach 9.3 percent in 2025. But if retail and corporate customers switch their banking to digital companies at the same rate that people have adopted new technologies in the past, the industry’s ROE could fall even further.

Yet technology is not just a threat to banks. It could also provide the productivity boost they need. Many institutions are already digitizing their back-office and consumer-facing operations for efficiency. But they can also hone their use of big data, analytics, and artificial intelligence in risk modeling and underwriting—potentially avoiding the kind of bets that turned sour during the 2008 crisis and raising profitability.

 

The Global Financial System is Less Interconnected—and Less Vulnerable to Contagion

One of the biggest changes in the financial landscape is sharply curtailed international activity. Simply put, with less money flowing across borders, the risk of a 2008-style crisis ricocheting around the world has been reduced. Since 2007, gross cross-border capital flows have fallen by half in absolute terms (Exhibit 5).

Global banks retrench

Eurozone banks have led this retreat from international activity, becoming more local and less global. Their total foreign loans and other claims have dropped by $6.1 trillion, or 38 percent, since 2007 (Exhibit 6).

Nearly half of the decline reflects reduced intra-Eurozone borrowing (and especially interbank lending). Two-thirds of the assets of German banks, for instance, were outside of Germany in 2007, but that is now down to one-third.

Swiss, UK, and some US banks have reduced their international business. Globally, banks have sold more than $2 trillion of assets since the crisis. The retrenchment of global banks reflects several factors: a reappraisal of country risk, the recognition that foreign business was often less profitable than domestic business, national policies promoting domestic lending, and new regulations on capital and liquidity.

The world’s largest global banks have also curtailed correspondent relationships with local banks in other countries, particularly developing countries. These relationships enable banks to make cross-border payments and other transactions in countries where they do not have their own branch operations.

These services have been essential for trade-financing flows and remittances and for giving developing countries access to key currencies. But global banks have been applying a stricter cost-benefit analysis to these relationships, largely due to a new assessment of risks and regulatory complexity.

Some banks—notably those from Canada, China, and Japan—are expanding abroad but in different ways. Canadian banks have moved into the United States and other markets in the Americas, as their home market is saturated. Japanese banks have stepped up syndicated lending to US companies, although as minority investors, and are growing their presence in Southeast Asia. China’s banks have ramped up lending abroad.

They now have more than $1 trillion in foreign assets, up from virtually nil a decade ago. Most of China’s lending is in support of outward foreign direct investment (FDI) by Chinese companies.

 

Foreign direct investment is now a larger share of capital flows, a trend that promotes stability

Global FDI has fallen from a peak of $3.2 trillion in 2007 to $1.6 trillion in 2017, but this drop is smaller than the decrease in cross-border lending. It partly reflects a decline in corporations using low-tax financial centers, but it also reflects a sharp pullback in cross-border investment in the Eurozone.

However, post-crisis FDI accounts for half of cross-border capital flows, up from the average of one-quarter before the crisis. Unlike short-term lending, FDI reflects companies pursuing long-term strategies to expand their businesses. It is, by far, the least volatile type of capital flow.

 

Global imbalances between nations have declined

Ben Bernanke pointed to the “global savings glut” generated by China and other countries with large current account surpluses as a factor driving interest rates lower and fueling the real-estate bubble. Because much of this capital surplus was invested in US Treasuries and other government bonds, it put downward pressure on interest rates. This led to portfolio reallocation and, ultimately, a credit bubble. Today, this pressure has subsided—and with it, the risk that countries will be hit with crises if foreign capital suddenly pulls out.

The most striking changes are the declines in China’s current account surplus and the US deficit. China’s surplus reached 9.9 percent of GDP at its peak in 2007 but is now down to just 1.4 percent of GDP. The US deficit hit 5.9 percent of GDP in its peak at 2006 but had declined to 2.4 percent by 2017. Large deficits in Spain and the United Kingdom have similarly eased.

Still, some imbalances remain. Germany has maintained a large surplus throughout the past decade, and some emerging markets (including Argentina and Turkey) have deficits that make them vulnerable.

 

New Risks Bear Watching

Many of the changes in the global financial system have been positive. Better-capitalized banks are more resilient and less exposed to global financial contagion. Volatile short-term lending across borders has been cut sharply. The complex and opaque securitization products that led to the crisis have fallen out of favor. Yet some new risks have emerged.

 

Corporate-debt dangers

The growth of corporate debt in developing countries poses a risk, particularly as interest rates rise and when that debt is denominated in foreign currencies. If the local currency depreciates, companies might be caught in a vicious cycle that makes repaying or refinancing their debt difficult.

As the corporate-bond market has grown, credit quality has declined. There has been notable growth in noninvestment-grade “junk” bonds. Even investment-grade quality has deteriorated. Of corporate bonds outstanding in the United States, 40 percent have BBB ratings, one notch above junk status. We calculate that one-quarter of corporate issuers in emerging markets are at risk of default today—and that share could rise to 40 percent if interest rates rise by 200 basis points.

Over the next five years, a record amount of corporate bonds worldwide will come due, and annual refinancing needs will hit $1.6 trillion to $2.1 trillion. Given that interest rates are rising and some borrowers already have shaky finances, it is reasonable to expect more defaults in the years ahead.

Another development worth watching carefully is the strong growth of collateralized loan obligations. A cousin of the collateralized debt obligations that were common prior to the crisis, these vehicles use loans to companies with low credit ratings as collateral.

 

Real-estate bubbles and mortgage risk

One of the lessons of 2008 is just how difficult it is to recognize a bubble while it is inflating. Since the crisis, real-estate prices have soared to new heights in sought-after property markets, from San Francisco to Shanghai to Sydney. Unlike in 2007, however, these run-ups tend to be localized, and crashes are less likely to cause global collateral damage. But sky-high urban housing prices are contributing to other issues, including shortages of affordable housing options, strains on household budgets, reduced mobility, and growing inequality of wealth.

In the United States, another new form of risk comes from nonbank lenders. New research shows that these lenders accounted for more than half of new US mortgage originations in 2016. While banks have tightened their underwriting standards, these lenders disproportionately serve lower-income borrowers with weaker credit scores—and their loans account for more than half of the mortgages securitized by Ginnie Mae and one-third of those securitized by Fannie Mae and Freddie Mac.

 

China’s rapid growth in debt

While China is currently managing its debt burden, there are three areas to watch. First, roughly half of the debt of households, nonfinancial corporations, and government is associated, either directly or indirectly, with real estate. Second, local government financing vehicles have borrowed heavily to fund low-return infrastructure and social-housing projects.

In 2016, 42 percent of bonds issued by local governments were to pay old debts. This year, one of these local vehicles missed a loan payment, signaling that the central government might not bail out profligate local governments. Third, around a quarter of outstanding debt in China is provided by an opaque shadow banking system.

The combination of an overextended property sector and the unsustainable finances of local governments could eventually combust. A wave of loan defaults could damage the regular banking system and create losses for investors and companies that have put money into shadow banking vehicles.

Yet China’s government has the capacity to bail out the financial sector if default rates reach crisis levels—if it chooses to do so. Because China’s capital account has not been fully liberalized, spillovers to the global economy would likely be felt through a slowdown in China’s GDP growth rather than financial contagion.

 

Additional risks

The world is full of other unknowns. High-speed trading by algorithms can cause “flash crashes.” Over the past decade, investors have poured almost $3 trillion into passive exchange-traded products. But their outsized popularity might create volatility and make capital markets less efficient, as there are fewer investors examining the fundamentals of companies and industries.

Cryptocurrencies are growing in popularity, reaching bubble-like conditions in the case of Bitcoin, and their implications for monetary policy and financial stability is unclear. And looming over everything are heightened geopolitical tensions, with potential flash points now spanning the globe and nationalist movements questioning institutions, long-standing relationships, and the concept of free trade.

The good news is that most of the world’s pockets of debt are unlikely to pose systemic risk. If any one of these potential bubbles burst, it would cause pain for a set of investors and lenders, but none seems poised to produce a 2008-style meltdown.

The likelihood of contagion has been greatly reduced by the fact that the market for complex securitizations, credit-default swaps, and the like has largely evaporated (although the growth of the collateralized-loan-obligation market is an exception to this trend).

But one thing we know from history is that the next crisis will not look like the last one. If 2008 taught us anything, it’s the importance of being vigilant when times are still good.

 

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The Focus

Restoring confidence in the banking system through Improved regulatory standards

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Banks are often regarded as the life-giving force of an economy and the heart of free market economies. They are important in providing funding sources to a country by granting loans to individuals, companies and governments and acting as a “safe-box” for depositors. Banks, thus have the potential of helping to fuel economic growth, creating jobs, raising incomes and peoples’ standard of living and self-realization.

Equally, banks can wipe out trillions of dollars of wealth around the world, bringing capital markets and economies to a brink of collapse. The 2007-08 global financial crisis resulted in worldwide banking regulation reforms in different scales, with more stringent regulations on bank capital, liquidity and corporate governance structure being seen as the best way to restore the stability of financial markets.

Over the last two decades, the banking regulatory environment and supervision have been broadened to cover various types of risks, differentiate between asset classes of different risks and allow for a variety of approaches to determine the risk weights to be applied to each asset category. In the process, the rules have become increasingly elaborate, reflecting the growing complexity of modern banks.

Among the reasons for maintaining close regulation of banking institutions is the concern that certain domestic and global developments could lead to another banks failure. The objective of the regulator therefore is to avoid situations in which the government would have to support a struggling bank or let it collapse. The issue is that providing aid to crippled banks could create a situation of moral hazard. The general premise is that while the government may have prevented a financial catastrophe for the time being, it reinforces confidence for high risk taking and provides an invisible safety net.

This can lead to a vicious cycle, where banks take risks, fail, receive a bailout, and then continue to take risks once again. The problems were compounded with the coming into effect in January 2017 of IFRS 9 in the country. One cannot therefore deny the fact that the banking industry needs high regulatory standards, including sound corporate governance practices, to build public trust and confidence and also operational credibility to promote the safety and soundness of the banking system.

Corporate Governance Challenges and Failures

The challenges and failures of corporate governance in Ghana stems from the culture of corruption and lack of institutional capacity to develop, implement and enforce the codes of conduct governing corporate governance in the banking sector. Banking executives enjoy an atmosphere of lack of checks and balances in the system and therefore engage in gross misconducts since investors and/or shareholders are excluded in the governing structures.

The BoG’s policies and procedures for ensuring efficient internal controls are in most cases disregarded, and a total lack of thorough selection process of CEOs and board members remain a challenge in the country. Lack of managerial training and capacity building of Ghanaian executives to manage business risks have in many instances resulted in huge agency costs. Shareholders have therefore had to shoulder several avoidable agency costs since the board of directors usually fail as a monitoring device to minimize agency problems.

The failure of corporate governance in the Ghanaian banking industry is also attributed to lack of effective framework for evaluating board and management processes and performance, since board sub-committees required to be fully independent, especially the audit, risk and remuneration committees, are sometimes compromised.

Auditors and audit committees of boards have in many instances been singled out as instruments of fraudulent activities, given their readiness to cover-up corrupt practices in return for kick-backs. The IMF, on several occasions has stated that the failure to adhere to good corporate governance practices have contributed to the poor financial performance of banks in the country.

Another critical challenge that Ghana faces in implementing financial regulation is the issue of capacity (human and technical) for effective regulation and supervision. Although the country has made significant progress in acquiring capacity and resources, as well as putting in place rules and tools for effective regulation and supervision, significant challenges still remain. Many board members of banks lack the requisite skills and competencies to effectively redefine, strategize, restructure, expand and or refocus their banks on areas of new business acquisitions, branch expansion and products development.

Board of directors of many banks have inadequate knowledge, experience and competence relevant to the key financial activities their banks pursue in order to exercise effective governance and oversight. Boardroom squabbles sometimes become issues due to different business cultures and high ownership concentration, especially in banks that were formerly “one-man” entities.

Currently, a greater number of banks in Ghana have no robust risk management systems in place. Most banks have board committee for risk management, but few are aware of their current and future risk tolerance and strategy. Given the expected significant increase in the level of operations, these banks will be facing various kinds of risks which, if not well managed, will result in significant losses.

Awareness of corporate governance is generally low in the country and some shareholders do not know their rights. As a result, there is not enough shareholder activism to elicit changes in boards’ governance policies and practices, oversight of certain functions, company’s directors and executive compensation plans, etc. At annual general meetings, there is not enough probing of directors on the operations of the banks they have invested in.

What about stated minimum capital? The Bank of Ghana reviewed upwards the minimum capital required for new banks to operate in the country to GH₵120 million a few years ago. It is alleged that, to date not all the banks have managed to increase their minimum capital to GH₵120 million. If this is true, then how are the banks which have not been able to meet the GH₵120 million minimum capitalization expected to raise the new minimum capital requirement of GH₵400 million by the end of this year? And how did the Bank of Ghana come out with the new minimum capital requirement amount of GH₵400 million? When it comes to minimum capital requirement, hasn’t the time come for Bank of Ghana to set different levels for the tiers, indigenous and foreign banks since the latter can fall on their parent banks to raise the required funds? If extreme care is not taken, the current GH₵400 million minimum capital requirement will force an overwhelming majority of indigenous banks to sell greater portion of their shares to foreign investors, leading to increased domination of the country’s banking industry by foreigners, with serious foreign exchange risks for the country.

How best to manage risks from a more integrated financial system with the rest of the world in a situation of capital account liberalization also continues to confront the country. Increased capital account liberalization could result in inflows of foreign bank lending and portfolio capital, which in turn have the potential to create serious currency mismatches in banks’ balance sheets.

Foreign banks can magnify the risks, given the ease with which they can tap into foreign sources of funding for their lending and other activities in the country. There is therefore the need to have in place a supervisory framework for monitoring adequately the size of these mismatches and how they evolve over time.

Over the years, BOG has been making efforts to align its regulatory and supervisory framework with international standards, but important gaps remain. Several legislative improvements have been introduced and efforts have also been made to improve risk-based supervision as a precursor to implementing the Basel Accord. A sustained financial sector reforms has succeeded in creating one of the most vibrant financial services centers in the sub region.

Ghana has, therefore, seen a significant increase in the number of banks, including Pan-African groups, with a rapidly expanding deposit base. Despite the major accomplishments made at the legislative front and the efforts to strengthen supervision, the present banking industry is fairly saturated comprising 30 universal banks, 137 rural and community banks, and 58 non-banking financial institutions including finance houses, savings and loans, leasing and mortgage firms.

Given the interconnectedness of the banking industry and the national economy, it is very important for BoG to maintain control over the standardized practices of the banks. This is because without government bailouts, crippled banks will not only become bankrupt, but will create rippling effects throughout the economy, leading to systemic failures. This underscores why the licensing of an entity to operate as a bank should involve a comprehensive evaluation of the entity’s intent and the ability to meet the regulatory guidelines governing banks operations, financial soundness, and managerial actions.

Recent developments in the banking industry in the country makes one to question the robustness of the criteria used in evaluating entities for banking licenses. Are banking licenses granted on provisional basis pending the fulfillment of certain requirements?

The transition of Ghana’s banking industry to IFRS commenced in 2006 but after 10 years of application, most of the Ghanaian banks are yet to comply fully with the requirements of the IFRS. In December 2015, the BoG issued out the Basel Guidance on Credit Risk and Accounting for Expected Losses for banks to follow in order to achieve high quality implementation of IFRS 9. Additional Guidance on IFRS 9 implementation for banks and other licensed institutions was issued out to take effect on January 2018.

The purpose of this guidance is to introduce further clarifications and guidelines, set initial minimum provision thresholds to credit risks, or other supervisory requirements of the BoG in relation to periodic deadlines and any other necessary reports and submissions.

The fact is that, the IFRS 9 on its own is demanding and challenging. For example, asset classification under IFRS 9 is more stringent than BoG rules. Even with strict application of BoG rules, a facility which is current under BoG rules may be underperforming or non-performing under IFRS 9. Unfortunately, it seems that not enough preparation and coordination for the implementation of IFRS 9 has taken place as was the case with the initial application of the IFRS in 2006.

Lots of uncertainties and challenges, including the unavailability and poor quality of historical credit loss data, absence of good database, inadequate IT systems, and lack of skilled and well-trained human resources continue to be a challenge to many banks in the country. Meanwhile the lack of historical credit risk data will make the transition to the new accounting standard, IFRS 9, very challenging. In April 2016, BoG wrote to all banks requesting them to perform IFRS 9 impairment impact assessment, using their 2016 financial statements, and submit the assessment to it by end-June 2017.

Was this assessment by banks made and the results submitted to BoG? If yes, what did the BoG make of the assessments? Why is BoG not focusing its efforts on ensuring that banks overcome the availability and quality of historical credit data challenges, knowing the impact of this on IFRS 9 application? Why is the BoG going ahead with the new minimum capital requirement when the banks are yet to address fully their IFRS credit and data gaps?

Overall, macroeconomic developments in Ghana since 2014 have not been impressive in recent times. The Ghanaian economy encountered significant macroeconomic challenges in 2014 due, in part, to high and extraordinary fiscal and current account deficits during 2012-2013. The year 2014 was extraordinarily difficult for Ghanaians as the Government had to contend with both domestic imbalances, especially in the fiscal area, and severe terms of trade and exchange rate shocks.

The growing economic imbalances resulted in heightened financial fragility and uncertain expectations, which led to rapid outflow of capital and increased the probability of a severe crisis as a result of a falling exchange rate and rising interest rate. BoG reacted to the increased capital outflow in February 2014 by announcing new measures intended to restore stability in the foreign exchange markets. Under the new rules, commercial banks and other financial houses were banned from issuing cheques and cheque books on foreign exchange accounts and foreign currency accounts. The new measures also provided that all undrawn foreign currency-denominated facilities should be converted into local currency-denominated facilities.

The Bank of Ghana also directed that no commercial bank should grant a foreign currency-denominated loan or foreign currency-linked facility to a customer who was not a foreign exchange earner. The Bank also prohibited offshore foreign deals by resident and non-resident companies, including exporters in the country. It also prohibited over-the-counter cash withdrawals from foreign exchange and foreign currency accounts not exceeding US$10,000 or its equivalent in convertible currency per person per travel, and this was only be permitted for travel purposes outside Ghana.

The above foreign exchange control measures were introduced by BoG following pressure on the local currency, which depreciated sharply within the first few months of 2014. However, in spite of these measures, the local currency continued to depreciate against all the major foreign currencies. Many policy analysts and the business community found the reaction of the central bank somewhat perplexing given that the underlying drivers of the instability were familiar in Ghana’s recent economic history.

As it became apparent that the measures were not working optimally and the business community continued to express their frustrations about the foreign exchange restrictions, the central bank relaxed some of the restrictions and later had to withdraw them entirely. Doesn’t the BoG know that such on-and-off policy reactions undermine the credibility of the financial system and confidence in the economy? 

Addressing the Corporate Governance Challenges and Failures

The recent initiatives of the Bank of Ghana (BoG) aimed at improving and strengthening governance practices in the banking sector are steps in the right direction. The adoption of a Risk-Based Supervision Framework and Corporate Governance Regulations for the banking industry will indeed help to overcome many of the challenges confronting the industry.

In December 2010, the Basel Committee on Banking Supervision (“the Committee”) published its report “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.” Essentially, this report was the Committee’s response to the global financial crisis and the shortfalls of its predecessor, Basel II. The formulation of these reforms is commonly referred to as Basel III and is aimed at improving the regulation of banks’ capital and liquidity regimes.

The implementation of Basel III impacts banks’ cost of funding and consequently the rate at which banks are prepared to lend. Further, it may also reduce lending by banks to more risky asset classes, as capital held may be used to pursue more profitable, less risky transactions that do not attract a relatively high risk weighting in terms of the Basel III rules. The IFS is of the view that Basel III be implemented in a phased approach so that the full impact of it on the cost of borrowing will not be known for some time. However, it is reasonable to conclude that the cost of borrowing will increase as a result of the increased capital holding requirements, lower leverage ratios and higher liquidity requirements.

In March 2018, the Banking Business–Corporate Governance Directive 2018 was issued to

  • Regulate financial institutions to adopt sound corporate governance principles and best practices to enable them perform their role in enhancing economic growth in Ghana;
  • Promote and maintain public trust and confidence in regulated financial institution by prescribing sound corporate governance standards which are critical to the proper functioning of the banking sector and the economy as a whole; and
  • Minimize the possibility of regulated financial institution failures that are usually rooted in poor corporate governance practices. All the banking regulations and corporate governance guidelines issued by the BoG since 2015 are designed to ensure full implementation of IFRS 9 requirements. In fact, the BoG requires local banks to comply with IFRS 9 in their quarterly publications in 2018 towards transition to the publication of first IFRS 9-compliant financial statements.

To ensure full compliance to IFRS 9, BoG should take it upon itself to organize a series of workshops on “risk-based supervision” and “corporate governance regulations” for boards of directors of the local banks to help strengthen capacity in effective banking regulation and supervision. Board members should be required to ensure a demonstrated corporate culture that supports and provides appropriate norms and incentives for professional and responsible behavior as an essential part of good corporate culture.

Directors must also ensure that their banks maintain an effective relationship with the BOG. This will enable the BoG to impress upon the board of directors to exercise their “duty of obedience”, “duty of care” and “duty of loyalty” to the bank as required under the Banking Act 2004, Act 673 as amended by the Banking Amendment Act 2007, Act 738 and supervisory standards. It will also help directors to ensure that banks maintain an effective relationship with the BoG.

Indeed the Basel Committee on Banking Supervision recommends that new and existing board members must be trained continuously to deepen their knowledge and skills to fulfill their responsibilities. The responsibility for accurate and truthful financial and regulatory reporting, including mandatory public disclosure, should also be placed on board of directors. It is also time for a disclosure of remuneration packages of senior management and directors emoluments to be made mandatory in the country. 

There is no doubt that weak regulatory standards, especially poor corporate governance practices lead to banks distress and failures. As Atuahene (2016) and others have established, the impact of poor corporate governance practices on the distress in the Ghanaian banking system is manifested in loss of confidence by the banking public, liquidity squeeze on the part of distressed banks and nonperforming risk assets which result in high loan loss provisions that impact negatively on banks capitalization policy.

The regulatory and supervisory regime in Ghana has evolved over the years to meet the changing structure of the Ghanaian financial industry as well as the risk levels associated with the pace of expansion. These prudential regulations relating to banking and non-banking financial business aim at achieving a sound and efficient banking system in the interest of depositors and other customers of these institutions and the economy as a whole.

However, there remain cross-cutting challenges that need to be addressed. The Bank of Ghana, with an overall supervisory and regulatory authority in all matters relating to banking business in the country, has to ensure a sound, competitive and efficient financial system. It is therefore a welcome news that BoG is taking steps to strengthen banking regulatory requirements, including the issue of corporate governance practices in the banking sector, to prevent widespread distress and failures.

It is known that bank distress in the country has been caused in part by the excessive exposure, macroeconomic instability, weak corporate governance practices, poor lending practices, and weak risk management practices. The IFS supports the call on the Ministry of Finance, which has the overall responsibility over the country’s fiscal and financial matters and the BoG, the regulator of banking activities to take steps to develop, implement, and supervise corporate and financial governance structure in the country.

The current economic environment of the country also exposes banks to a plethora of risks but in employing appropriate frameworks and structures that promote good corporate governance practices, BoG should be careful not to pursue this agenda out of context. The fact that Ghana is not entirely insulated from financial globalization, nor is it immune from its potentially destabilizing effects, or from the challenges it creates for the national financial regulatory authority does not mean that we should adopt fully the complex regulatory approaches designed for developed financial systems without taking into account our own peculiar circumstances.

The state of our economy, business environment, people, nature of politics and governance, presence of foreign banks in our jurisdiction, etc. should all be taken into account in designing rules and regulations for our banking industry.

 

 

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