BUSINESS WORLD Enforcing the Minimum Capital Base Requirement for Commercial Banks: Challenges of the Sierra Leone Central Bank Posted by on Feb 3, 2010, 16:48

Towards the end of 2009, the Central Bank  of Sierra Leone raised (at least on paper) the minimum capital base requirement of commercial banks from around Le 5 Billion to Le 15 Billion for a start in 2010 and Le 30 Billion in five years time. Many of us that heard the news gave two thumbs up to the Central Bank, the Bank of Sierra Leone (BSL) for a job well down.

We congratulated the Bank Governor at the time for attempting to bring serenity to the banking system. We did this on the backdrop that since the country’s banking sector was very fragile due to the financial crisis and the low banking public of just around 400,000 bankers, the banking sector needs to be protected from unscrupulous Chief Executive Officers (CEOs) and staff of commercial banks operating in the country.

The fear of a banking crisis occurring in this country became even more imminent when news about the Nigeria’s banking crisis began filtering into this country, country that is home of the head offices of majority of the banks operating in this country. It even became worse, when it became clear that bad banking and greed were the major causes of the crisis in that country.  Poor lending practices, excessive risk taking, poor governance, lack of internal controls, focus on market share rather than profitability, and currency and maturity mismatch in the banks themselves or among their borrowers.

The issue of collateral is becoming the source of banking crisis in developing countries, especially where the regulatory framework is weak. Big businesses and individuals have the required collateral and as such have access to commercial bank loans. However, many of these ‘big time’ borrowers normally find it difficult to pay up their debt. Worst of all such borrowers are difficult to pursue, given their status in society and their political connections.

The situation is even aggravated if bank executives have little at stake in the banks, that is, do not have enough capital invested in the banks; and if bank managers carry little personal responsibility for the risks they take. Certainly, in the case of the banking crisis in Nigeria, the amount of risk that bank managers chose to take on exceeded what was socially optimal because of limited liability.

Regulation

Many analysts pointed out that bad banking could only persist in the absence of proper regulation and supervision, and of adequate market discipline.  Weak supervisory frameworks may include allowance for concentrated lending, portfolio mismatches, inadequate loan valuation that overstate bank profits and capital, incompetent management, etc. This is why many of people have been calling on the Central Bank to do more to protect the customers of commercial banks and the Sierra Leone economy in general.

It is a fact that the regulatory framework requires that banks should pursue prudent lending activities; and this meant adherence to strict lending norms as per regulatory requirements. However, the short-term nature of the liabilities of commercial banks dictates that the better regulatory frame work should hit directly the balance sheet of commercial banks to prevent them from taking unsecured risks. This is why the raising of the capital base requirement for these banks was viewed as a step in the right direction.

The presence of risk therefore creates the need for some measure of the value for a bank, such as its net worth, against which debt-holders can claim if the bank becomes illiquid. The bank’s net worth, or economic capital, is closely associated with the book value of capital recorded in the bank’s balance sheet. Minimum capital requirements are designed to ensure that the bank preserves its net worth. The leverage ratio requirement sets a lower bound for the ratio of a bank capital to total assets.  A low net worth limits the ability of the bank to honour its liabilities to depositors should the bank become insolvent.

Additionally, low net worth of banks make it difficult for these banks to access funding since the banks’ creditors will not want to take on the risk of unsecured lending. Finally, there are moral hazard implications since it is argued that a low net worth means that the owners of the bank have a lower proportion of their wealth at stake should the bank fail and will therefore have an incentive to undertake more risky ventures. These propositions suggest that there is a strong relationship between bank’s capital or net worth, its risk and leverage requirements and its portfolio choice.

Enforcement of Regulations

By the laws of Sierra Leone, all commercial banks operating in the country should follow and comply with the regulations and directives of the central bank, the Bank of Sierra Leone.  Such regulations include complying with the capital base requirement set by BSL for all commercial banks by the end of 2009. Although this policy was a laudable undertaking on the part of the central bank yet the efforts of the Governor to bring serenity to the banking sector are about to go down the drain just as many other bogus policies of government functionaries.

As at now less that six (from a total of 14) banks have complied with BSL capital base requirement regulation. Even though the dead line for all commercial banks to comply (by end December, 2009) has passed, yet those that have not complied are still allowed to operate unhindered-business as usual. In fact, many observers have pointed out that the capital base requirement policy of the central bank is nothing but the “barking of a toothless dog”.

This underlines the ability of government agents not only to formulate policies (which many of them are good at) but also to follow through on those policies, and to make sure that they are implemented to the letter. The Bank of Sierra Leone has raised the Capital Requirement for all commercial Banks, yes! So what? This action of the Central Bank by itself will not bring serenity to the banking sector; the policy has to be enforced to avoid a banking crisis in our already impoverished nation.

Commercial Banks

We know that commercial banks are organizations that provide services by receiving deposits and use these for funding revenue-generating assets. They are not just mere institutions that would only receive cash or cash equivalents for deposits and place them for safe-keeping. They could also function as an intermediary between the depositors that provide funds and the debtors that use the funds for businesses or other purposes. They can perform foreign currency trading as well as trading securities.

They can extend loans and profit from it through the accompanying loan interest. They can also perform other transactions apart from deposits and credit loans.  Commercial banks accept cash and check deposit accounts where depositors can deposit in cash or check items. Other transactions that can possibly be made in a commercial banking institution are cash withdrawals of depositor; promotion, acceptance and extension of loans; and fund transfer that can involve checks drawn from other banks. Commercial banks can also provide services including the promotion, application and processing of credit cards.

They can also administer the credit card accounts. Commercial banks can also involve in trading particularly in foreign currency exchange. They can set the rates of specific foreign currencies for buying and selling to interested clients although the rates have been based from the world foreign exchange market. Foreign exchange rates set by commercial banks may equal to or slightly lesser than the current rates in foreign exchange market. But normally, banks may set rates lower than the current exchange rates in the market to produce a gain from the transaction.

Given these vital functions of commercial banks, it is important that they are protected from collapsing; and such means is by raising the minimum capital requirement. This serves a cover for savers in the event the bank collapses, so that savers will not lose all their savings. Conventionally, the higher the minimum capital-base of banks the strong and the more resilient the banking system. Those banks that are unable to meet the minimum capital requirement will either merge with other banks or are forced to close down completely.