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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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