Regulating systemic risk in the Nigerian Capital Markets

Tumultuous yet propitious capital markets

In these times of austere growth in world economies, the 1.5% growth forecasted for Sub-Saharan Africa and the 2.9% forecast in 2009 for Nigeria is hardly modest, exceeding global growth forecasts by 3-4%. With a conservative estimation of the population of over 150 million people and 72 million in the workforce, Nigeria as the 9th most populated country in the world offers one of the more attractive investment prospects in the current economic climate.

Given the austere growth in mature world economies, there is much scope for growth in the Nigerian capital markets. Yet, as the major world economies in 2008 tethered on the brink of a financial meltdown, the capital markets in Nigeria were also undergoing a tumultuous experience. The market capitalization fell from a high of N13.5 trillion ($USD 1 billion) in March 2008 to less than N4.6 trillion by January 2009. Although the causes of the decline in the Nigerian capital markets were unrelated to the financial crisis that originated in the United States and spread through the other economies of the developed world, the consequences nonetheless had far reaching effects on the Nigerian markets.

Given the loss of confidence occasioned by the precipitous correction in the Nigerian capital markets, I offer a framework for analysis that suggests that we utilize the correct historical precedent to view the market correction, that we ensure that we conduct a proper diagnosis of the problem, and that our analysis of the historical precedent and diagnosis of the problem, moving forward, informs our proposed policy responses to stabilize the capital markets.

 The right historical precedent

The events of in 2008 could be analyzed in the context of several market crashes including the 1673 Dutch tulip bulb crash (prices skyrocketed in frenzied futures trading with each tulip bulb reaching the equivalent of $25,000 today), the South Sea Bubble of 1720 (shares in the South Sea Company rose to over ten times their initial value before all the value was wiped out), the Florida Real Estate Craze (property values soared over ten times their value before crashing to pre boom levels), and the 1929 Stock Market crash in the United States (over 80 percent of the value of the market was wiped out). More recently, the 1987 Crash (22.6%, or $500 billion lost in one day), the Asian crash, and the DotCom crash (The Nasdaq Composite lost 78% of its value) and the global credit crunch in 2009 ($30,000bn wiped of the value of shares worldwide).

The relevant historical precedent for the Nigerian market correction is the 1929 crash in the United States. For anyone who has studied the crash of the US stock market in 1929, the events of the 2008 market correction in Nigerian markets paints eerie historical parallels. First, there was very limited competition in the US market with large single entities controlling large segments of the primary industries (utility, transportation and entertainment industries), a situation similar to the structure of the Nigerian capital markets today. Second, as in the Nigerian banking sector today, there were questionable credit allocation decisions because of an inadequate banking system and substantial information asymmetry between issuers and investors.

The causes of the market correction

There have been numerous explanations regarding the causes of the market correction. These include suggestions that stocks were overpriced and that the crash brought share prices back to a normal level. Some point to high levels of fraud and illegal activities, as well as over-exposure to margin loans.  Others point to the global financial crisis and the exit of foreign investors from the Nigerian capital markets, inadequate infrastructure causing constraints on the real economy, the commercial banks repeated fundraising from the markets, diversion of available capital to private placement offers, the failure of the government to put together a bail-out plan for the market, the absence of a market maker function, and statements of public officials that stocks were overvalued. Before some these conclusions about the causes of the market harden into conventional wisdom, it seems worth inquiring whether the right questions were asked, much less whether the right answers were reached.

One recurring explanation that does merit further analysis concerns the connection between margin lending and the correction in the Nigerian capital market. Similar to Nigeria, at the time of the 1929 crash, the exposure of the US banks to the stock market was not only high because of their investments, but their exposure was exacerbated by the high number of individual investors who had borrowed heavily on margin to buy stocks. Although much has been said about the impact of margin lending on the 1929 market crash, margin buying accounted for about 5% of the market value of the stock market and similar to the situation in Nigeria, cannot entirely explain the downturn in the market.

In my view, any one explanation and I have reviewed many, inevitably oversimplifies what was a complex and long-developing set of vulnerabilities. In this context, it is important to note that the market correction was not simply an aberration, a failure on the part of certain market operators, but deeper systemic flaws in our current regulatory framework.

In my view, explanations of the market correction that suggest that the design of our regulatory framework unduly emphasizes the micro-prudential (a focus on the individual) aspects of the regulatory framework often at the expense of macro-prudential and systemic ramifications (systemic risks) of our capital markets, which recent developments have indicated are key to financial stability go much further in explaining the market correction. This clearly calls for greater collaboration among various regulators and for strengthening our understanding of the interface between micro-prudential and macro-prudential issues.

Charting a regulatory framework to focus on systemic risks

Applying the apt historical precedent and focusing on the macros prudential issues suggests that we inject a normatively superior approach to our policy making. This point can, of course be rephrased as a set of binary policy choices. If the correction was a consequence of the actions of a few market operators, the proper policy response would be a more vigorous enforcement of our regulatory framework. On the other hand, if the correction stemmed from a more fundamental failure of the existing regulatory framework, then what is required is a thorough overall of the existing framework governing the operations of our capital markets.

Acknowledging that the market correction indicated a systemic failure within the regulatory framework for the Nigerian capital markets requires that in addition to the fault allocating exercise which is required, also more importantly needed is a prospective revamp of the current regulatory framework to guard against future corrections. Given that regulatory resources are finite, we need to make informed choices with respect to where we focus our regulatory resources. This requires that we develop methods that enable regulators to focus on critical threats to the efficient operation of the capital markets. It in this context that risk analysis will serve as a tool for informed decision making. Risk-based regulation is advantageous because it inherently requires regulators to incorporate cost-benefit judgments into the focus of finite regulatory resources on firms or activities that pose the greatest threat to the integrity of the marketplace.

In closing, the need to restore confidence in the integrity of our capital markets has never been greater. The damage to individual investors is a constant reminder of the urgent need to act to strengthen the regulatory framework of our capital markets and put our economy back on track to a sustainable recovery. We must build a new foundation for capital markets that is simpler and more effectively enforced, that protects the everyday investor, that rewards innovation and that is able to adapt and evolve with changes in our growing economy.

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Corruption – an opening salvo

In seeking to label conduct as corrupt, the word has been used to describe behavior ranging from broad formulations that include any behavior that falls outside accepted norms to conduct that focus on exchange of money that induces public officials to break the law. In fact, what is immediately clear from the range of conduct that have been described as corrupt is the absence of agreement on what constitutes corruption or an accepted definition of what exactly is corruption. Labeling conduct as corrupt thus suggests to me the word is being used not as an analytic claim, but a semantic one. In other words, ascribing different meanings to the word suggest a more serious set of concerns – that the uses of the word corruption come out of a history of real theoretical conflict or confusion. That the word is used in different ways and contexts is in part a semantic armistice to that conflict or confusion.

Corruption and culture – a transnational discourse
So what does the semantic armistice with respect to the word corruption have to do with the discourse between developed and developing country on the issue? Well lots, especially if you view the discourse within the context of the relationship between domestic morality and transnational policy. This discourse takes place within the rubric of the relationship, if any, between corruption and culture. More importantly, the rhetoric of the discourse casts the problem of corruption as a domestic problem in which developing countries bear the cost of the corruption through stunted development. The rhetoric ignores the fact that corruption owes its current salience in the international arena to the concerns regarding the effects of corruption on foreign investors. Once the anti-corruption campaign is viewed in the context of its impact on foreign investors, the arguments against corruption lose their retardation of development rationale and become primarily a question of redistribution between foreign and local investors.

Without taking a position on the efficacy of the law in effecting social change, it is indisputable that legislative strategies to combat transnational bribery have both a supply and demand side. The demand side of bribery refers to demands or requests for bribes by public officials. The supply side of bribery refers to offers of bribes to public officials. A corrupt transaction can be initiated in either way. There are therefore supply side solutions and demand side solutions to curbing transnational bribery by corporations. The supply side solutions seek to impede prospective bribe-givers from offering or paying bribers. The demand side solution discourages prospective bribe-takers from accepting or requesting bribes. Initial efforts at curbing bribery focused on the demand side, with most countries enacting legislation prohibiting the receipt of bribes. In recent years, these have been supplemented by supply side solutions to transnational bribery through the adoption of extra-territorial prohibitions on transnational bribery. In part, at least, this has been a response to the perceived ineffectiveness of mechanisms for the regulation or control of bribery in the place of its commission.

One man’s anti-corruption crusader is another’s terrorist
Over the next couple of postings, I intend to explore the contours of the word corruption – its definition, the causes and consequences of corruption. At this stage, it is important that I manage expectations. If you are expecting erudite condemnation of corruption in developing countries, you are probably reading the wrong blog. If on the other hand, you are looking for a serious analysis of the issue of corruption within the African continent and intend to develop pragmatic solutions to temper the effects of corruption particularly on those living in poverty, then please soldier on. One important caveat and in providing this caveat, I will share the thoughts of the Harvard University Law professor Duncan Kennedy. He points to the lack of clear arguments by those who oppose the current anti-corruption campaign being waged by the international community suggesting that the thinking is that if you oppose the campaign, then you must support corruption. In effect, to oppose the features of the current anti-corruption campaign places one uneasily outside the common sense of the international community. Duncan posits that although it is widely recognised that ‘one person’s terrorist is another’s freedom fighter’, one is not permitted to speak in favour of terrorism, and likewise, despite the difficulty in defining corruption, in polite society one must be opposed to it. It is important moving forward that we recast the question whether one should or should not have an anti-corruption campaign into the different question – whether the current campaign against corruption is the most effective way of bringing about the sea change that we need to see on the continent.

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A cross disciplinary perspective on corruption

A cross disciplinary perspective
One thing that struck me reviewing the literature on the definitions of corruption is the remarkably different ways that the word is viewed across the disciplines.

The anthropological literature has focused on the values that participants in a transaction that could ascribed as corrupt give to their actions. In this view for instance, the anthropological literature has analysed bribery in the context of traditional gift-giving practices. Studies by economists view corruption as a function of scarcity. In this view, because the demand for goods is greater than the supply, there is tendency for these goods to rise over and above their official price, the difference between official and actual price represents the bribe that can be extracted.

In the sociological literature, corruption is often viewed as a function of power-status relationships represented in the violation of socially accepted norms of duty and welfare. In this view, the system of unequal rewards in the society serves as the drive for the commission of acts of corruption. For political scientists, the occurrence of corruption within a society is viewed as a symptom of more deeply rooted problems in the society’s structure related in particular to the means of attaining and maintaining power. This particular approach to corruption suggests that bureaucratic corruption, for instance, is an informal means of exerting influence at the enforcement stage of the political process.

The cross disciplinary perspective on corruption is much broader than the examples listed above and the approaches ranging from anthropological and sociological investigations of ‘gift-giving’ practices through to historical, institutional, psychological studies and economic analyses of corruption. One thing that is clear from the various approaches is that whether corruption is viewed in terms of illegality, immorality or some other standard, the choice of perspective reflects the focus and purpose of each discipline and reflects the kind of questions he hopes to provide answers for in his study.

Corruption as interest articulation same as voting?
The formulation by the political science discipline I found particularly interesting. This formulation views corruption as an extra-legal institution used by individuals to gain influence over the actions of bureaucracy. An illustrative example would be the UK government trying to pass a law that prohibits smoking in public places. First of all, the government would probably seek public consultation on the issue and when the legislation is finally passed, it would be passed by an elected parliament. As a citizen of the UK, you participated in the passage of the law and even if you do not agree with it personally, it reflects the view of the majority. So when the policeman stops you on the street and arrests you for smoking in contravention of the law, there is some moral force to the implementation of the law.

In a developing country where people are disenfranchised and have very little or no influence over their political institutions, the only time that the citizen actually has the opportunity to influence the particular legislation prohibiting smoking in public places is at the stage when the police man walks up to him to enforce the law. In the view of the political scientist, the offer to bribe the police man represents individuals participating in the decision-making process of the society, albeit at the enforcement stage rather than the stage at which the law is being passed. The crucial factor however remains that participation takes place at the enforcement stage rather than at the time before the decision is made. In this sense, corruption is a form of influence albeit an illicit form of influence. In this formulation of corruption, the act of corruption is used by an individual or groups to get what they want from government, or prevent actions they do not want, often drawing upon many of the same resources as more conventional forms of influence.

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