The world financial crisis of 2007-2009 remains one of the most severe economic shocks recorded to date. Most economists have cited it as the worst economic shock after the Great Depression of the 1930s. At the centre of the 2007-2009 crisis is a financial system that was bleeding profusely as a result of heavy investments in subprime mortgages. Many financial institutions around the world including banks that were considered “too big to fail” folded and the contagion risk was so great that it cast the whole global financial system into trouble.
The financial system in Zimbabwe has not been performing well since the banking crisis of 2004. Most of the issues bedevilling Zimbabwe’s financial sector are largely structural and these include capital composition, risk management and corporate governance. Some of the problems in the financial sector have come up as a result of depressed economic activity.
After the global financial crisis, the financial system in the developed world has been restructured in a way that enables it to be resilient in the wake of adverse economic shocks. Most advanced economies changed the capital regulations, corporate structures and investment limits in a move to protect the financial institutions against adverse economic factors. Technically, Zimbabwe is in a recession and it is the vital lessons of the Great Recession our financial institutions and monetary authorities need to take note of.
The Great Recession in every way virtually impacted on most financial institutions around the world. Banks and insurance companies that were undercapitalised felt the impact with most of them folding. This is because they did not have the resources to insulate them from the economic catastrophe.
In my previous articles I have always advocated for banks to hold enough capital (preferably in liquid or near-liquid form) that is able to cover liquidity, operational and credit risk. If the economic downturn Zimbabwe is facing persists, it is quite evident that some of the financial institutions which are undercapitalised in terms of the specific risks they face will not be able to sustain their operations any longer.
Before the situation explodes it is vital that monetary authorities consider periodic analysis of bank capital to avoid scenarios where banks fold overnight. Contingency plans have to be in place to avert bank failures.
The lesson of the Great Recession is clear in that during turbulent times banks have to be in a position in which capital is able to act as buffer.
No institution is too big to fail
Lehman Brothers, Northern Rock and Bear Stearns were some of the biggest financial institutions in the world and commanded billions in investments, but folded as a result of the housing market bubble which burst. The world’s largest insurer, the American International Group, was not spared as well as it had to be bailed out by the American government. To most observers this was unprecedented, but the most important lesson is that there are no sacred cows in the financial industry. It is vital for financial institutions in Zimbabwe, large and small, to institute proper policies and procedures that always safeguard their going concern status especially in these turbulent economic times because no bank is too big to fail.
Most financial institutions accrue the bulk of their income through provision of credit. As a result banks lend as much as they can so as to make enormous profits for themselves. Before the Great Recession many banks were engaging in high risk lending activities which ultimately led to high rates of delinquency and default. Many of the big banks in the United States, for example, were saddled with loss incurring portfolios that contained poor quality loans. Some of them, including Washington Mutual Bank, the sixth largest bank in the United States at the time, paid the ultimate price of folding operations.
The fact that non-performing loans are a big issue with Zimbabwean banks and micro-finance institutions point to the fact that there is something wrong with the credit policies they follow. Far from the rationality of bankers and financiers in Zimbabwe is the realisation that a poor credit management system can drag a financial institution into the mud. It is imperative for financial institutions in the country to put into place robust credit management systems as well as hold enough capital to counter credit risk.
Most micro-finance institutions in Zimbabwe have largely been engaged in high risk lending especially to consumers, but the bubble will burst soon considering events such as the on-going retrenchments in the private sector and the uncertainty of salary payments in the public sector. It is vital for banks and financiers to stick to the prudential limits of credit management as the lesson from the Great Recession where institutions folded as a result of high risk lending has been illuminative in that regard.
From the housing market, the Great Recession of 2007-2009 went on to infect the banking sector, capital markets, insurance and almost every sector of the economy. Contagion risk is corrosive in the banking sector than any other industry. The failure of Lehman Brothers, for example, threatened the existence of other banks and set off turmoil in financial markets worldwide.
Monetary authorities in Zimbabwe must constantly monitor troubled banks as these have the capability of polluting the whole financial system and economy. With the current liquidity crisis, it is imperative that monetary authorities classify financial institutions according to the specific risks they face and put up stern measures to avoid any contagion that is detrimental to the whole financial system.
Heavy investments in the mortgage business led to the collapse of banking giants like Lehman Brothers. The case would have been different if some of the banks that collapsed during the time of the Great Recession were exposed to different spheres of the economy rather than one particular sector which in this case was housing (sub-prime mortgages).
To avoid this scenario, Zimbabwean banks which are lending, if there are still any, must spread their exposure across various sectors of the economy. Exposure to one sector can lead to the collapse of a whole bank as the sub-prime mortgage crisis has taught us.
Sticking to core business
Prior to the sub-prime mortgage crisis, there was a lot of creativity in the financial sector. New products and trading mechanisms were developed. Derivative trading strategies were constantly changing. Short selling, credit default swaps, futures and forwards were synonymous with the Great Recession. Not that there is anything wrong in these financial instruments, but over-indulgence can be catastrophic. This over-indulgence stems from the desire to make riskless profits but also there is no guarantee that returns can always be realised.
As Zimbabwe is hamstrung by a weak economy it is important for the financial sector to stick to its core business. Deviation from the standard course of business activity or experimenting can be detrimental.
De-regulation is not the answer
The motto of hard-core capitalists from the days of Adam Smith to present day is that when it comes to commerce the best government is no government. This implies that for businesses to succeed government regulation should be minimal or non-existent. In the 1980s-90s most American banks advocated vigorously for deregulation where they sought the non-involvement of government in the way they conducted business. Ultimately there was deregulation of the financial markets but it backfired in 2007 with the bursting of the housing market bubble.
Banking is a fragile industry where too much and too less of government control can be poisonous. There is need for fiscal and monetary authorities to constantly monitor and supervise the activities of financial institutions whilst maintaining and insisting on their independence. This will protect depositors and other counterparties to which these institutions are exposed to, while granting them the freedom to make profit.
Makaha is a financial consultant. New Perspectives articles are coordinated by Lovemore Kadenge, president of the Zimbabwe Economics Society e-mail: email@example.com, cell +263 772 382 852.