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Tempest in a Tea Pot: Money, Banking and the Central Bank (II)

By A. Eze Nwagbaraji
Effective Central banking requires the ability to be part of the market and understand fully the inner workings of the global nature of money, even beyond national borders.

Economic Historians as far back as the time of Adam Smith understand the umpire role of a central authority to referee the workings of national economies and control the self centered interests of individuals and private participants in the market. No less than the Patron Saint of Economists, Adam Smith himself wrote poignantly about this in his two most famous writings _ the Theory of Moral Sentiments and the Wealth of Nations. While the Wealth of Nations emphasized the role of self interest, the Theory of Moral Sentiments argued for concerns or sympathy for others with the understanding that rules provide effective guide.

The NDIC is a clear statement that insolvency risks exist in the banking sector, hence the assurance to depositors that in those cases, deposits are guaranteed. This also requires the NDIC to create effective supervision mechanisms of the insured banking institutions. Insolvency risk is a market condition not unique to banking. However, countries create deposit insurance companies to protect depositors and sustain confidence because of the unique importance of the banking system in national economies. The five banks now in receivership in Nigeria are all members of the NDIC and each come under the supervision of the NDIC.

A bank failure is the closing of a bank by the federal supervisory and regulatory authorities. This only happens when both the CBN and the NDIC conclusively decide that the target banks are not in a position to meet their obligations to their “depositors and the government agencies are not in a position to carry out their duties to the bank customers.

When a bank fails the primary responsibility of the NDIC is to pay the insured customers in a prompt and timely manner to protect depositors’ financial interests and maintain public confidence in the system. In bank failure, the receiver reconciles the bank’s assets (including physical assets) with debts and moves to settle all creditors, including those with funds in excess of the insured deposit requirements.

The history of central banking since the 17th century has been one of determined efforts to provide level playing grounds for the conduct of national and international commerce. Along the way, economists and monetary experts have acquired the tools necessary to soften the impact of random or systemic implosion of the banking sector. Risbank, the oldest formal central bank in the world was opened by Dutch businessmen in 1668.

In 1694, William Paterson, the Scottish businessman, at the request of the English Crown opened the Bank of England to assist the English government pay for its wars.

While I7th. 18th. and 19th century central banks were tied to the gold standard, when the gold standard collapsed after World War II, central banks tied to national currencies became common. The US Central Bank (The Federal Reserve Bank “the Fed”) was created by Congress in 1913 with the passage of the Glass Owen Bill, signed by President Woodrow Wilson. Australia set up its central bank in 1920, Colombia 1923, Mexico and Chile, 1925, Canada 1934 and New Zealand 1935. African countries in rapid successions set up central banks upon independence.

To buttress the importance of central banking, Communist China in attempts to expand market reforms and adopt capitalist approach turned the People’s Bank of China into a central bank in 1979 and today, the People’s Bank of China is the largest holder of various national currencies and national bonds, including those denominated in the US Dollar, the Pound Sterling and the Euro.

Monetary and Banking Regulatory Authorities unarguably have the instruments of state power to propel or cripple national economic systems. The boom and burst economic cycles are largely the creations of central bankers or a result of their inability to properly
manage monetary policy.

Low interest rates stimulate borrowing and banking activities. Expansion of credit facilities expand money supply and empower commercial banks to expand the synthetic money supply system within their reach. The fundamental question for monetary economists and observers is whether central bankers have the necessary tools to understand the magnitude of their conducts in the market place.

Central Banks are monopolies and operate in environments of limited competition or zero competition within their national boundaries. Combine this with the elitist posture of Central Bank officials, one is confronted with a double edge problem of individuals who may have limited knowledge of the business world, but because of the accolades that surround their professional life are accorded absolute respect.

The only organs of government that Central Banks deal with are the executive and members of the legislature when there are needs to go before the legislature. Even before these government organs, central banks adopt the posture of lecturing. This is responsible for the rush by several Nigerian legislators to tacitly stay mute in the current crisis that has embroiled the banking sector and some have come out in support of the CBN without any attempt at weighing the consequences of the on going crisis.

Commercial banks are engaged in fiercely competitive businesses and have direct reach to the foot soldiers of the business world, i.e. business men and women who are captains of numerous national industries. These businesses engage in national commerce in search of profits. They adapt technology and global knowledge at a faster rate than any operator within a monopoly will ever understand.

Implications of Bank Failures

A bank fails economically when the market value of its assets decline below the market value of its liabilities, so that the market value of its capital (net worth) becomes negative. At such times, the bank cannot expect to pay all of its depositors in full and on time.

A bank failure is also an admission that the regulatory and supervisory authorities have been negligent in their duty to supervise or regulate. It leads to the loss of shareholders invested assets and diminishes investors’ confidence in the banking sector.

The perception of failure in the banking sector is very important for public policy because of the spill over effect and the damage to market confidence. The current crisis surrounding the Nigerian banking sector is bound to have a spill over effect on all financial services. A national financial crisis affects all the domestic business sectors and sends a market shock unlike failure in any other industry or national business sectors.

Other factors why contagion in the banking sector acquire heightened national importance include the complex and intertwined relationship between commercial banks in the economy. Banks lend and borrow from each other. A failure of one bank to meets its obligation to another may lead to a default in the non_contaminated bank’s ability to meets its obligation to other banks. This may have a rippling effect on the entire banking sector.

Banking is also an intellectual (knowledge based) business. Value retention in knowledge based assets diminishes at a faster rate than in other forms of assets. A bag of cement is worth a fixed number of bricks or blocks to a bricklayer, irrespective of what happens to the cement manufacturer. This is not the case in banking.

It is the duty of the CBN and the NDIC to ensure the safety and soundness of our banks through appropriate supervision. This does not eliminate the risk of bank failure, but limits it. Proper banking supervision is a case by case approach focused on ensuring that each bank management has in place policies and operating procedures that will contain risks. It is further the duty of the supervisor to ensure that bank management adhere to the risk containment procedures.

In their regulatory capacities, the CBN and the NDIC must have the capacity to prescribe and proscribe what must and what must not be done in specific areas of banking. Regulations are backward looking because they are adopted in response to specific problems. However, after half century of operation, the CBN should have large pool of scenarios and experiences garnered from our local banking experience and those learned from global markets.

Market changes and innovations require changes in regulations and technology have provided banking with one of the most important tools in this area. The importance of safety and sound supervision and regulation of commercial banks in Nigeria can be properly appreciated by the uproar and concerns from the public following the August 14, 2009 announcement by the CBN that five of the country’s largest banks have gone into receivership.

Orderly resolution of banks’ failures required the CBN and the NDIC to source amicably, replacement of the distressed banks management and ownership structure. It is also the duty of the CBN and the NDIC to devise amicable ways of dealing with the banks defaulted creditors. The media hoopla that precipitated the announcement and the shock to the market, the loss in asset values, and diminished values are not sound and prudent regulatory conduct.
Nigerians are not defending the reckless act of bank managers and directors. Prudence require that those implicated in criminal acts be prosecuted.

Regulators must also act in manners that retain the investing public’s trust in the banking and financial system. The CBN and the NDIC had added responsibilities to protect the invested capital of those who acquired bank shares. Infusing public funds into private banks should be a partnership in equity ownership. Not a license to dispossess long term investors in the affected banks. Our capitalist system need this risk takes if we must expand the market economy.


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Comments expressed here do not reflect the opinions of vanguard newspapers or any employee thereof.