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Excess liquidity in banks …bane or blessing

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After writing a series of articles emphasizing liquidity as the life blood of banks and financial institutions, readers may be surprised about the above heading. I have deliberately chosen to sound a warning to banking and finance practitioners about the potential for excess liquidity to breed recklessness in investment decision making, if not managed effectively. Indeed, excess liquidity can be as bad as illiquidity!

It is just like reminding readers that sugar is sweet, but the availability and excessive consumption of sugar can kill and not even the witches will accept responsibility for such apparent suicide.

Whether or not a bulge in liquidity, emanating principally from the mandatory capital injection requested by the central bank would lead to an expansion of bad loan portfolios is a highly debatable topic. Some have opined that there is not much quality investible outlets to absorb the additional capital. They argue further that the availability of additional capital alone is not a catalyst for economic growth, to which the banks are expected to be central pillars.

This group of people even mention the absence of a robust enabling environment, pointing to the need for a paradigm shift in how the court and land administration systems negatively impact banking and finance operations.

Some have suggested that in the same way as the Ghana Revenue Authority is busy conscientizing the citizenry about the need to honour their tax obligations, there must be a similar and even more pressing need for the central bank and other state and civil society organizations to spearhead a clarion call on borrowers to honour bank loan repayment obligations.

Others have quickly countered that enough projects are in the horizon for the banks to support. What with the government’s intention to revive the rail sector and the enormous opportunities for private sector participation? What about the sea port expansion, the roads and related infrastructural projects, and the yawning opportunities in the aviation, agricultural, industrial, oil and gas sectors, and the one district one factory (1D1F) mantra?

Another school of thought, however, holds the view that clear policy prescriptions are still needed to clarify the extent of private sector participation in these apparently grand schemes. For the 1D1F initiative, for instance, some believe that little appears to be said about incentives, local raw materials components, how final output from these industries would compete with imported substitutes, among other grey issues. Do we continue with the open-ended import regime that stifles local production?

Further clarification would enable the banks and financial institutions to identify and set their risk appetite parameters in line with the increased capital. The banks are ready to respond to any laudable initiatives. How much risk a bank is willing to take is a function of its risk appetite which must be approved by the board, and usually communicated through a risk appetite statement.

Risk appetite is determined principally by the quantum and mix of capital and deposit liabilities, volatility of earnings, the availability of skilled personnel and the assessment of other environmental factors like the present or future state of the economy. The political and legal framework, the social and technological dynamics prevailing at a time or likely to exist in a pre-determined time horizon also affect the investment appetite of financial institutions.

Risk appetite may vary from one bank to the other, depending on the unique circumstances of each bank, and the factors stated above. Even for the same bank, risk appetite may not be static. It must reflect strategy, which includes the bank’s objectives, key aspects of the business, economic cyclicality and stakeholder expectations over time.

Other enabling environmental factors beyond the control of the various bank boardrooms are the twin issues of national identification and property addressing systems, the perennial problems of the budget deficits financing and the current account deficit in the balance of payments, both of which have significant effects on inflation and exchange rates simultaneously.

The question of whether bank credit expansion creates economic growth or economic growth fosters bank credit expansion have been examined in several economic development literatures. From whichever angle one debates the issue, the centrality of credit and the role of the financial intermediaries can hardly be ignored, given particular capital adequacy considerations and the bank’s embedded capacity to create credit through the multiplier effect.

In the midst of all these is the expectation of the shareholder or funds provider for appropriate return on equity. Bank boards are going to be under increasing pressure to meet the expectations of shareholders. The reality though, is that in the short term, at least, the probability of a dilution in return on equity cannot be downplayed.

Bank executives would naturally be examining their liquidity in terms of rising capital adequacy levels   in excess of mandatory requirements. The specific deposit mix of the individual banks will play a major part in how much credit could be extended.

The central bank is reported to have said that commercial bank borrowing from the regulator has seen a downward trend; an indication that either the banks are slowing down their loan portfolio expansion in the wake of deterioration of quality or that the gradual injection of new capital has boosted liquidity which is yet to be deployed.

Readers and other risk professionals familiar with the multifaceted causes of the American financial crisis of 2006- 2008 cannot shy away from the role of excess liquidity in the sub-prime lending during the debacle.

For starters, the American economy was awash with liquidity flowing from many oil producing countries which had generated windfalls from the then global fuel price hikes. These countries and their financial institutions obviously needed investible outlets for the accumulated funds. Expectedly, most of these funds found their way into the United States – the world’s biggest and strongest private sector led economy. Liquidity was therefore bursting at the seams and needed to be deployed, hence the evolution of complex securitization schemes aided in part by rating agencies.

A series of interventions, partly aided by a deliberately held low interest rate regime, a government intent on making housing delivery affordable to low income earners through the Community Reinvestment Act (CRA) and Fannie Mae/Freddie Mac, caused lenders to reduce standards in order to expand credit. The government tacitly encouraged financial institutions to make subprime home loans to those at the lower end of the income scale.

In no time, there was an abundance of loans to people who could not afford to repay them.  Compounding issues was a rise in executive emoluments tied to targeted loan book expansion, which in itself bred irresponsible risk taking, with eyes fixated on related bonuses. Eventually these loans went into default in large numbers, and that partly fueled the financial crisis.

Fingers were pointed at regulatory ineptitude and financial innovation that went awry or just didn’t live up to its promises of risk-sharing and risk-reduction. These created an excess of liquidity, with even jobless persons getting access to loans in expectation of future jobs- the NINJA loans (no income, no jobs, loan beneficiaries)

Why am I making inferences to the role excess liquidity played in the American financial crisis? The reason is that some elements of the crises appear to be playing out in the current Ghanaian banking and financial environment.

First is the issue of re-capitalisation which is not restricted to the universal banks. It is a sound requirement given the banks’ shrinking balance sheets, emaciated from high non-performing loans provisions, and until recently high rates of inflation. All the other non-bank financial institutions are under pressure to also increase their capital levels, just as the insurance industry regulator is requesting similar schemes from practising firms.

One can easily foresee intense pressure in the micro-finance arena where lenders’ operational wings have been clipped by the regulator in terms of the maximum loans they can give out or even deposits they can mobilise from single persons. Individually and collectively, that sector is going to lose out on competition to mainstream banks, which are capable of undercutting the former by lower interest charges. The natural urge to survive might push the micro-finance industry into less favourable lending schemes or they may hold on to excess liquidity, while their fixed costs bite them callously.

Evidently, to whom much is given, much would be expected. This holds equally true with the boards and management of these financial institutions who would be expected to produce higher returns on the additional equity, in an economy that has virtually stagnated over the last ten years. A relentless drive for market share could result in lowering credit standards as happened in the US.

Equally instructive to note is that, the central bank’s prime rate has seen a downward trend. The banks are expected to follow in a similar vein, constrained by other non-interest charges that impinge on their profitability.

How far these falling interest rates can be sustained in an economy whose fundamentals have hardly changed in the past decades remains to be understood. Just like the American borrowers who gleefully accepted adjustable rate mortgages at a time of low interest rates without bothering about their vulnerability to upward rate changes that they had signed up to, Ghanaian borrowers must be sensitized to understand that variable rate bank loans include a clause that permits the bank to adjust rates in tandem with prevailing conditions. The customer’s liberty to pay interest only while the principal is carried forward merely postpones doomsday.

Thus, if interest rates begin to rise to reflect the dynamics in the market, borrowers would be shocked, just like their American counterparts, that suddenly they cannot afford the adjustable rates; defaults would set in, re-possessions would rise and provisions would have to be made for loan losses, as the slow court processes exacerbate the banks’ difficulties.

That excess liquidity from re-capitalisation and potential deposit growth, coupled with intense competition can lead to reckless loan book generation is not an imagination of this writer. We witnessed   similar predatory lending practices leading to a bulge in loan expansion across the industry during the second half of President Kuffour’s tenure. The result was banks literally chasing customers to offer loans even in areas the banks had no footprint or could be ably supported by technology towards loan recoveries. Expectedly loan losses rose rapidly during the period.

To allay the fears expressed here, the regulator needs to assure us that better supervision than that which festered the dramatic corporate governance breakdowns in the erstwhile UT Bank and Capital Bank would reign supreme this time round. The pervasive permissiveness still lingering in some of the existing banks must be checked.

Of particular interest would be how the various bank boards of directors perceive their stewardship roles; their responsibilities, accountabilities and need for transparency. They should be able to rein in errant chief executives and their management from reckless loan expansion, much of which usually stems from unethical and unprofessional practices, and short-term expediencies. A failure to learn from history can be catastrophic for the financial market as government bail- out in Ghana seems less likely under the crunch of reducing budget deficits and prevailing high debt service ratios.

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