Prudential Regulation And Central Banking Policy

PRUDENTIAL REGULATION AND CENTRAL BANKING POLICY

INTRODUCTION

Adequate bank regulation and supervision are crucial prerequisites for both financial stability and flexibility, (Polizatto, 1990). To a certain extent, supervision can substitute regulations as it does in Britain. Clearly, regulations cannot replace supervision, (Fry, 1995). Regulations are of two dimensions, viz economic and prudential. Economic regulation refers to regulation designed to achieve economic goals e.g. reserve requirements, directed credit and credit allocation etc. prudential regulation refers to the set of laws, rules and regulations that is designed to minimize the risks bank assume and to ensure the safety and soundness of both individual institutions and the system as a whole. Examples include lending limits, minimum capital adequacy ratio and liquidity ratio.

Central banks in most countries have primary responsibility for some economic goals, and the prudential regulation of the banking systems. Economic goals of the central bank usually have implication for bank prudential regulation, whether the central bank is the bank supervisor or not. The pursuit of central bank economic goals and prudential regulations banks are related in some ways especially if the considered against the fact that, a successful implementation of the economic goals of the central bank will depend on the safety and soundness of the banking system. This paper therefore attempts to examine the design and implementation of central bank economic policy goals and its implications for prudential regulation.

The paper is structured as follows: Part II, examines the main issues and elements of prudential regulation, Part III, analyses, the design and implementation of central bank policy goals for prudential regulation. In Part IV, are the concluding remarks.

THE MAIN ISSUES AND ELEMENTS OF PRUDENTIAL REGULATION

Prudential regulation establishes the limit and constraints placed on banks to ensure the safety and soundness of the banking system. It is the key element in preventing, limiting, or stopping the damage caused by poor management. The establishment of an appropriate regulatory framework is thus essential to ensure that the supervisory authorities can carry out and enforce their responsibilities. Notwithstanding the necessity of an appropriate regulatory framework, it is important to recognize that regulation cannot preclude all bank failure. However, good regulatory measure can facilitate efficient supervision that serves to minimize the adverse impact of moral hazard and relative price shock on the financial system. The main prudential measures required to ensure the establishment of a sound banking industry includes restricting the composition of banks’ assets, liabilities and capital by setting balance sheet requirements such as capital adequacy, loan classification and provisioning standards and liquidity requirements, etc.

Capital Adequacy

Capital is necessary to absorb unusual losses. Often, capital as a cushion for unusual losses is simply not sufficient for the risks that exist on and off the balance sheet. Banks’ potential for failure is greatly enhanced if capital is lacking because as they are undercapitalized, management is often forced into holding losses that would make insolvency apparent. Without appropriate action, this unhealthy situation may continue until banks face a liquidity crisis and the government is forced to act. To combat these problems, the authorities specify a minimum capital adequacy. By the 1988 Basle Accord, the capital adequacy ratio (CAR) is set at 8 percent expressed as the ratio of total qualified capital to total amount of risk assets. The assets and off balance sheet transactions are assigned risk weights that are meant to reflect the relative credit risk of those assets. A higher weighting brings with it is a requirement for a higher capital base, meaning that dividends would not be permitted in the wake of high weighted risk assets or when the CAR is less than 8 percent. However, this percentage may need to be increased on a case-by-case basis because of a bank’s particular risk profile or where substantial off-balance sheet risks exist. Thus given that the purpose of capital is to absorb unusual losses, the measurement of capital adequacy should be related to the areas of greatest risk, that is, assets and off-balance sheet contingencies.

Liquidity Ratio

The maintenance of adequate liquidity ration to meet all obligations as they fall due is fundamental to banking. Banks should be able to manage liquidity in such a way as to generate resources sufficient to cover the potential outflow of funds. The ability to meet obligations may be provided by holding cash and other liquid assets. Thus the liquid assets ratio includes such as government securities or good quality commercial papers which provide the necessary liquidity to meet the obligations of a bank but are out the monetary authority’s control.

Other Elements of Prudential Regulations

The other elements of prudential regulations include criteria for entry, asset diversification, assets classification, loans to insiders and permissible and prohibited activities. Since most small banks fail because of poor management and connected lending, the initial decision to grant a license is an important one. Unfortunately, in many developing countries licenses are granted by agencies of the government other than those with direct supervisory responsibility. Often the granting of licenses is politically motivated and is a form of patronage or is designed to serve a special interest group, e.g. agriculture or housing. Where this has occurred, problems and banks insolvency have often followed. To minimize this type of problem, prudential regulation should be such as to screen access to ownership and management to prevent individuals lacking professional qualifications, experience, financial backing and sound ethical standards from obtaining a banking license. The ease or difficulty of complying with the above regulation could be used as a means of regulating new entrants into the market place.

Banks can increase returns or reduce risks or generally achieve a better combination of risk and return by diversifying operations. Restrictions on geographical expansion or product diversification often increase the exposure of banks to particular risks. From the prudential point of view, such restrictions should not be condoled. However, lending limits, investment limits and other exposure limits, which prevent the concentration of risk in a single borrower or a related group of borrowers are necessary for prudential purposes. Such limits are normally expressed as a percentage of a bank’s capital. In high income countries, credit to any borrower cannot normally exceed 15 or 20 percent of capital. In some developing countries, lending limits may not exist, while some may adopt lending limits which are often circumvented by borrowers who borrow through nominees. In general a lending limit of 10 0r 15 percent of bank’s capital is appropriate. At no time should it exceed 25 percent of bank’s capital.

One of the remote causes of bank distress is the failure to recognize problem assets through classification, provisioning, write-off and interest suspension. The inability to detect problem assets, establish realistic provision for potential losses, write-off or fully provide for actual losses or suspend interest on non-performing assets, result in the balance sheet not reflecting bank’s actual condition while the income statement profits upon which dividends and taxes are paid. One way to realistically identify problem assets and provide adequate reserves for possible losses is to:

• Classify bank assets as to quality according to specific criteria;
• Define non-performing assets;
• Require the suspension of interest and reversal of previously accrued but uncollected interest on non-performing assets;
• Preclude the financing or capitalization of interest; and
• Update minimum provisions to the reserve for possible losses based on the classification of assets.

A frequent cause of loan problems is credit granted to bank insiders, which more often than not, does not only fail to meet the same standard extended to outside borrowers, but also has its amount exceeding prudent level. Moreover, bank officials connive with highly placed board members to grant large unsecured loans to themselves and their companies (Ologun, 1994). Limits are therefore set on loans to insiders, including large shareholders and related companies. These limits do not only restrict the amount of credit but also require that the terms and conditions of such credit are not on more favourable terms than credit extended to outside borrowers with similar qualifications.

Prudential regulation does not permit banks to spread their activities to all imaginable areas. Even within their recognized areas, they are not to expand without control. Banks are also provided the conditions under which they can expand fixed assets acquisition and disposal. All these are constantly reviewed against the banks’ financial and general performance.

DESIGN AND IMPLEMENTATION OF CENTRAL BANK POLICY GOALS

A central bank has the responsibility for regulating the value of the national currency in such a manner that takes the country’s welfare into the consideration. Consequently, the central bank strives to stabilize the said value as far as possible in order to contribute to the orderly and balanced economic growth of the country and the external stability of the currency and to act as banker and financial adviser to the government. This simply means the central bank must follow policies that will ensure that the community has an adequate stock of money and other financial assets. The pursuit of a stable currency has implications for the nation’s external reserves and a sound banking system.

To ensure a stable national currency there should be adequate external reserves to back the domestic currency, while to enhance confidence in the value of the currency, the banking system that creates it must be sound and healthy. An unsound banking system may pose a threat to the integrity of the payment arrangements; affect the transmission of monetary policy signals and resource allocation. Bank supervisors, in turn are interested in having stable currency, since high volatile inflation may emit wrong market signals, causing misallocation of resources which may increase the potential for bank failures. Thus the determination of the adequacy and stability of the money stock is the most crucial of central bank’s policy goals.

Design and Determination of Money Stock

A nation’s money stock is jointly created by the central bank and the deposit taking institutions particularly commercial banks. Thus to determine the money stock, it is necessary to analyze the consolidated balance sheets of the central bank and the deposit taking banks known as the monetary survey (see Appendix 2)

Monetary Survey

The monetary survey consist of two component parts viz the liabilities side and assets side, the two of which must balance.

L = M1 + QM + OL ……………………………………………… (1)

Where

L  = Total liabilities

M1  = Narrow money stock

QM  = Quasi money stock

OL  = Other liabilities of the monetary system

M2 = M1 + QM ……………………………………………….. (2)

Where

M2  = Broad money

By substituting 2 into 1, we obtain equation 3 as

L  = M2 + OL ……………………………………… (3)

The assets side of the survey is stated as

A  = DC + NFA + OA ……………………………… (4)

Where

A  = Total assets

DC  = Domestic credit by the monetary system

NFA  = Net foreign assets of the system

OA  = Other assets

Since assets must equal liabilities, equation 4 must equal equation 1 as follows:

DC + NFA + OA = M1 + QM + OL …………………………… (5)

When equation 5 is re-arranged and M1 and QM made the subject of the equation, equation 6 is obtained as:

M1 + QM = DC + NFA + (OA – OL) …………………………… (6)

M2 = DC + NFA + OA’ …………………………………………… (7)

Where

OA’ = the other assets net

Equation 7 is the basic balance sheet identity. The left hand side variable(s) are classified according to type of liquidity while the right hand side variables are categorized by sectors. The NFA representing the inter-relationship of a country with the outside world thus captures the country’s balance of payment position while DC reflects the government budget operations and the system’s accommodation to private sector. Furthermore while the NFA is largely exogenous, the DC is mainly endogenous. Another significant feature of equation 7 is that it contains no behavioural assumptions and is therefore valid regardless of the economic system or policy mix.

For this identity to become a useful economic tool, a behavioural relationship – a stable demand for money –  can be introduced and the result is an operation that can be employed to balance aggregate demand with available resources.

M2  = f(Y, Õ, r) ……………………………………….(8)

Where

Y  = Gross Domestic Product (real)

Õ  = Inflation rate (percentage change in CPI)

r = Interest rate (it may be on short or long term deposit)

The parametric estimates of the explanatory variables are expected to have the following a priori signs:

1. dM2  > 0 Being the parametric estimate of Y

dY

2. dM2  < 0 Being the parametric estimate of Õ

dÕ

3. dM2  < 0 Being the parametric estimate of r

dr

The parametric estimates may be obtained by regression techniques covering fairly long period of observations.

Estimating the Determinants of Money Stock

Once money is estimated, the next stage of the design is to obtain the values on the right hand side of equation 7. Since foreign assets represent the inter-relationship of a country with the outside world, its size is usually influenced by the country’s foreign receipts subject to its terms of trade. The other assets (net), is estimated by trend factors. Thus as soon as the other assets (net) has been estimated and the target value for NFA fixed, the DC of the banking system 12 months hence can be calculated as:

DC  = M2 – NFA – OA’ ………………………………….. (9)

In other to determine the impact of fiscal operations on domestic credit (DC) and money, the DC is split between the government (NDCg) and the private sectors (DCp); consequently equation 7 reads in 10 as:

M2  = DCp + NDCg + OA’ + NFA …………………… (10)

Where

DCp  = Domestic credit to the private sector

NDCg = Net domestic credit to government

G – TR = NDCg + NBFg ………………………………….. (11)

Where

G  = Total government expenditure

TR  = Total government revenue

NBFg = Net government borrowing from abroad.

The NDCg is usually a policy variable which is influenced by the level of fiscal deficit or surplus. This is usually obtained from the central government and its size would in turn determine the size of DCp. The government budget constraint, (equation 11), shows that government expenditure (G) minus government revenue (TR) must equal its net borrowing from the domestic banking system (NDCg) plus net borrowing from abroad (NBFg). If the size of NBFg is small relative to the value of fiscal deficits, it would mean that substantial amount of domestic credits would be required to finance government sector deficits leaving the private sector with less credit than desired.

Finally it could be said that when the target levels for Y, Õ, r, NFA, NDCg and other targets are set, and the necessary policy measures to achieve these targets are spelled out, the monetary survey as represented by  equation 10 is completely forecast ex-ante and becomes the desired balance sheet of the central bank and the deposit taking banking system for the year in view.

Implementation of Central Policy Measures

Since money stock could in turn impact on its major determinants, it’s usually useful to put in place checks and balances to contain the undesired growth in money. This entails effective management procedures. Management embraces efficient implementation of policy measures which involves setting some standards or performance criteria; monitoring development and performance vis-à-vis the set standards; measuring any derivation(s) from target and analyzing them and taking further decision as to how variances could be eliminated or minimized.

In modern day market based environment, the most popular techniques for implementing central bank policy via indirect monetary techniques is largely open market operations (OMOs) which involves the sale and purchase of financial securities by the monetary authorities with the view to influencing the availability and cost of credit in the system in the desired direction. While credit, is the operating target under the direct control techniques, the base money could be said to be the operating target under the market-based technique. The following illustrate the basic relationship of the base money to money stock.

M2  = C + TD ……………………………………… (12)

Where

C  = Currency

TD  = Total deposit liabilities of the banking system

BM  = C + R …………………………………………. (13)

Where

BM  = Base money

R  = Total bank reserves

Dividing equations 12 and 13 through by TD respectively, gives the ff.

M2  = C + TD = c + 1 ……………………………. (14)

BM  = C + R = c + r ……………………………….. (15)

Dividing equation 14 by 15 we obtain

BM   c + r

Where

c  = the ratio of currency (C) to total deposit (TD)

r  = ratio of reserves (R) to total deposits (TD)

From equation 16, it follows that M2 can be expressed in terms of BM as:

M2  = c + 1 BM ………………………………. (17)

Where

(c + 1) = the money multiplier

On the assumption that the cash/deposit ratio of the non-bank public (c) and the reserve/deposit ratio of the deposit banks (r) are stable, it would be expected that the monetary authorities could control M2 by simply manipulating the BM. In the event the money multiplier is unstable, the money control strategy will involve first, the re-forecast of the appropriate multiplier and secondly, manage the BM. The BM is entirely the liabilities of the central bank, thus it could be expressed in terms of the monetary authorities balance sheet as:

BM  = CNFA + CNDCg + CCB + CCP + COA’………. (18)

Where

BM  = Base money

CNFA = Net foreign assets of the central bank

CNDg =  Net credit to government by central bank

CCB  = Credit to banks by central bank

CCP  = Credit to the private sector by central bank

COA’  = Other assets (net) of central bank

Given that BM is entirely the liabilities of the central bank and equation 18 holds at all times, it follows that for the authorities to achieve effective management under market based control, it would need to concentrate on monitoring and analyzing the right hand side variables of its balance sheet. Targets are therefore set for BM on annual, quarterly, monthly and weekly basis.

All the variables on the right hand side of equation 18 are endogenous, except CNFA which could be said to be exogenous. Thus appropriate policy measures are put in place to ensure that movement in source of BM do not destabilize the target BM. Depending on the statutory relationship between the central bank and the central government, the upper limit of CNDCg could be determined with some degree of exactness. The size of CCP would depend on the central bank’s developmental role in the private sector, while the CCB would be influenced largely by the Bank’s discount rate policy. The COA1 is usually at residual item which is expected to be small and insignificant.

However if during the course of the year, the ex-post BM grows or is predicted to grow beyond target, the authorities could remove any excess BM by the sale of treasury securities via  the OMO; raise the reserve requirements (r) and/or tighten the target, the authorities could buy back securities, lower the reserve requirements or relax the discount rate policy. The transmission mechanism from OMO to gross domestic products may be stated symbolically as:

Where

R = Bank reserves

K = Interest rate

I = Investment spending

S = Spending

GDP = Gross Domestic Product

EFFECTS OF CENTRAL BANK POLICY PURSUITS ON BANKS’ PRUDENTIAL ACTIVITIES

If there is a macroeconomic imbalance, such as money supply exceeding its optimum, the central bank could achieve its policy by a number of measures. It may decide to relieve the system of the excess money supply via OMO. In this case, the transmission mechanism will be as stated in equations 19 and 20 in the preceding section. On the other hand, if the central bank decides to raise the reserves requirement ratio, the transmission mechanism will also be as stated in equation 19 and 20. In either measures, it will lead to high interest rate which in turn might increase risk of loan default in the banking system. This may conflict with the objective to preserve the soundness of the banking system. However, an alternative situation is to relax monetary policy but this could be even more dangerous because it might worsen macroeconomic problems in the long run. From the central bank perspective, macroeconomic policy has a higher priority than dealing with the financial situation of individual banks.

Greater emphasis on macroeconomic goals by the central bank may be at the expense of bank prudence and supervision. For example, the central bank may limit new banking powers and investment in order to limit risks to the banking system and maintain the effectiveness of its existing monetary policy tools. This would result in decisions to expand banking powers, being based on their impact on the central bank’s ability to manage monetary policy and not on their benefits to the banking industry or their inherent risk. This disadvantage among others makes the suggestion for an independent banking supervisory agency worth looking into. Some countries have institutions distinct from the central bank, vested with the responsibility of bank supervision.

The pursuit of central bank policy goals may also induce changes in bank refinancing facilities, credit ceiling, exchange rates, the liquidity condition and market value of money market securities (Schmitz, 1993). All of these decisions affect the liquidity and profitability of banks. Also in the event of market failure, a central bank seeking to compensate for the so called market failure, may distribute credit to sectors that do not have easy access to loans through any of these measures – central bank rediscounting of certain commercial bank loans and specific lending by state development banks. Others are regulations mandating banks to lend a certain percentage of their portfolio to specific sectors and exempting banks that lend to priority sectors or geographical areas from holding a part of their reserves requirement.

Such directed credit portfolio have important drawback and their effectiveness is always questionable. Directed credit may distort the allocation of resources when they are diverted to projects with lower rates of returns than those that would result from a market allocation. Often they result in a significant share of non-performing loans in private and state development banks. For instance, preferential lending under government directives played an important role in the banking distress that developed in Bangladesh in 1990s (Watanagese 1970).

On the other hand, the pursuit of prudential guidelines by banks also affects central bank policy goals. For instance, the implementation of the Basle Accord may distort credit allocation or induce banks to adjust interest rates. The risk/capital assets ratio is known to create some incentives for banks to re-arrange their assets portfolios. Banks may also re-arrange their balance sheet to stretch equity capital over long-term activities by moving resources away from high risk weighted assets towards lower risk weighted assets. For example, since corporate lending carries a 100 percent risk weight, banks will be less inclined to finance this sector than they will to finance mortgage-backed loans, which have a 50 percent risk weight. Alternatively, banks may increase the interest rate differential between corporate and mortgage lending to cover the increase in capital costs.

To circumvent the costs of complying with capital/assets ratio, banks may resort to the securitization of bank assets, a form of bank disintermediation that in turn, weakens monetary control. By securitizing their loans, banks gets loans off their books. where monetary policy operates by directly constraining banks’ credit level, loans securitization raises concern about the effectiveness of direct control, because the operating targets are set at the level of the banking system accounts. But under indirect monetary control, loan securitization is of less concern because the operating targets of policy are set at the level of the central bank balance sheet.

CONCLUDING REMARKS

Prudential guidelines are issued to reduce and minimize the risk of systematic bank failure. The regulation requires banks to classify their assets and make stipulation provision for each classification, including banks’ off-balance sheet engagements.

A bank found with inadequate capital ratio is not allowed to pay dividend or acquire additional assets. Also banks are required to suspend interest on non-performing assets and to reverse previously accrued but uncollected interest.

The main central bank economic policy goal is the maintenance of a stable national currency. This single goal is all embracing as it means maintaining sufficient international reserves to give stable value to the domestic currency at all times and a sound banking system that will instill confidence in the national currency. In order to maintain a sound banking system, the authorities issue prudential regulations. Implementation of central bank policy goals could affect banks’ prudential behaviour especially where, the central bank in the pursuit of its macroeconomic goals neglects the micro effects of its goals on banks’ prudence.

APPENDIX 1

CAPITAL ADEQUACY COMPUTATION FOR COMMERCIAL/MERCHANT BANKS IN 1994

CAPITAL ADEQUACY COMPUTATION FOR THE MONTH OF ………..

NAME OF BANK: …………………

 

ASSET #000      RISK %        ASSET #000

1. CASH IN HAND      0
2. BALANCES HELD WITH

1. Other banks in Nigeria     0
2. Other banks outside

Nigeria (including foreign

Currency held)      0.2

3. FEDERAL GOVT STOCK     0
4. TREASURY CERTIFICATE     0
5. TREASURY BILLS      0
6. NEG. CERT. OF DEPOSIT     0
7. NON-NEG. CERT. OF DEPOSIT    0.5
8. INDUSTRIAL INVESTMENT     0.5

1. Loans to Fed. Govt.     0
2. Bankers Acceptances     0.2
3. Residential Mortg.

(O/Occup.)      0.5

4. Commercial Real Estate     1
5. Other Loans      1
6. Commercial Papers     1
7. Bills discounted      1
8. Interest in Suspence     -1
9. Under supervision      -1

9. FIXED ASSETS      1

10. OTHER ASSETS      1
11. CONTRA ITEMS (Contg. Liab.)

1. TOT. AMOUNT OF R. ASSETS    0.2

 

IST TIER CAPITAL

1. PAID-UP CAPITAL ……………………………………
2. STATUTORY RESERVE …………………………….
3. CAPITAL/OTHER RESERVE ………………………
4. GEN. RESERVE ………………………………………
5. PUBLISHED P & L A/C …………………………….

SUB TOTAL

LESS:

6. UNDER PROVISION
7. G/WILL & INTANGIBLE ASSET ………………….
8. UNPUB. LOSSES OF CUR. YR

TOTAL 1ST TIER CAPITAL …………………..

 

2ND TIER CAPITAL

1. LOAN STOCK OF A MINIMUM OF 7 YEARS

MATURITY (NOT EXCEEDING 50% OF 1ST TIER

CAPITAL …………………………………………..

2. DEBENTURE …………………………………………. 0
3. PREFERENCE SHARES/REV. RES………………. 0

SUB-TOTAL

LESS:

4. INVESTMENTS IN CONSOLIDATED

SUBSIDARIES & ASSOCIATES ……………………

TOTAL 2ND TIER CAPITAL

TOTAL QUALIFYING CAPITAL: (1ST & 2ND TIER CAPS) =

 

RISK WEIGHTED ASSET RATIO= TOT QUAL. CAP X 100

TOT AMT OF R. ASTS  1

PREPARED BY: ………………….    CHECKED BY: …..……………

 

APPENDIX 2

AN ACCOUNTING FRAMEWORK FOR MONETARY ANALYSIS

Monetary policy is greatly facilitated by an appropriate accounting framework. The following accounts are particularly important in considering the factors determining money supply.

• Monetary authorities: The monetary authorities are responsible for currency issue, credit control, managing the country’s international reserves and maintaining general supervision of the monetary system. These duties are usually carried out by the Central Bank of Nigeria in collaboration with the Federal Ministry of Finance and the Presidency.
• Deposit money banks: These are financial institutions, other the monetary authorities which have significant liabilities in the form of deposits payable on demand and transferable by cheque or otherwise usable in making payments. They are largely composed of commercial and merchant banks.
• Monetary survey is a consolidation of the accounts of the monetary authorities and deposit money banks that shows the financial relationship between the monetary institutions – whose liabilities include the economy’s money supply and other sectors of the economy. Schematically each of these accounts is shown below.

Monetary Authorities (A)

Assets        Liabilities

1. Foreign Assets      1. Reserve Money
2. Claims on Federal Government  2. Currency in circulation
3. Claims on Private Sector    3. Banks’ Reserves
4. Claims on Deposit Money Banks  4. Foreign Liabilities
5. Other Assets (Net)     5. Federal Government Deposit

Deposit Money Banks (B)

Assets        Liabilities

1. Foreign Assets (Net) (FA)  (a)  Money (M)
2. Domestic Assets (DA)  (b) Quasi-Money (QM)

1. Claims on Federal Government (Net)
2. Claims on Private Sector
3. Other Assets (Net)

FA + DA = M2 = M1 + QM