Tuesday, February 19, 2008

Challenges faced by Zimbabwe banks

Zimbabwe’s banking sector is under siege. Banks are being labelled all sorts things as the scapegoat finding season hots up. Banks and other institutions have been accused of holding “non-core assets” and engaging in “non-core” activities. As pointed out last week this presents Big Brother with a good sample to select appropriate whipping boys to open the latest round of “scapegoat finding season”.

The relevant question is how did it come to this ? And why did all banks find it necessary to do it ?Where were “the authorities“? It has to be beyond personalities. It’s a national problem and has to be treated as such. Those familiar with the sub-prime mortgage problems in the US and those in the UK will be more familiar with the recent or should I say current Northern Rock crisis. In the Northern Rock crisis the Bank of England has been forced to provide approximately £ 50 billion ( in $Z it’s a 5 with 21 zeros) to one bank to avoid a collapse due to a run on the bank. In the USA the Fed Reserve has had to inject billions of dollars. In December all major central Banks including US Fed ,Bank of Canada ,Bank of England, Swiss central bank and European Central Bank used combined effort and resources to inject more than US$200 billion to stabilise the financial markets. The point here is Banks can not be allowed to fail. Banks and financial institutions can not be allowed to collapse. The failure of a Bank is symptomatic of a bigger underlying structural problem emanating from beyond the bank.


The banking system developed when, people deposited gold coins,precious metals and silver coins at goldsmiths for safe keeping, in return of a note for their deposit. Slowly the notes became a trusted medium of exchange an early form of paper money was born, in the form of gold certificates and silver certificates.
Over time the notes were used directly in trade, the goldsmiths observed that people would never redeem all their notes at the same time, and exploited the opportunity to issue new bank notes in the form of interest paying loans. These generated income—a process that enhanced their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. When creditors (the owners of the notes) lost faith in the ability of the bank to exchange their notes back into coins, many would try to redeem their notes at the same time. This was called a bank run and many early banks either went into insolvency or refused to pay up.

Banks are required to keep on hand only a fraction of the funds deposited with them which allows the function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Banks make money from various products and services .These include interest on loans, fees and margins on forex trades. It must be noted banks have to make money regardless of the operating environment. And for this to happen banks have to develop various products and services that match their operating environment. This article is a brief look at how the Banks operating environment has been poisoned to make it almost impossible for them to stay afloat whilst focusing on traditional “core-activities” and holding “core -business-assets”

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex and related markets currently is over US$ 3 trillion.Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks, and are subject to forex scams and arrests in the case of Zimbabwe‘s black market. In many markets there is bureau de changes which help mobilise foreign currency. In Zimbabwe these were outlawed in one of the early “scape goat finding” seasons, when they were blamed for fuelling the black market.

The Zimbabwe forex market was further reduced by various regulations which essentially tried to centralise the market whilst simultaneously paying an unrealistic exchange rate .This action has deprived the banks of an important fee and income generating product and service. Banks would normally source forex,be its custodian and provide a ready and perhaps more transparent market for forex. Banks generally knew the exporters and the importers. As such Banks were better placed to match these participants requirements and earn a fee or some income in the process.

This cant be viewed in isolation. The other main area a is bank is supposed to make money is on loans through interest income. The RBZ has come up with various programmes providing subsidised funding .These facilities whose rates are as low as 25% include the Agricultural Mechanisation Program (AMP), the Agricultural Sector Productivity Enhancement Facility (ASPEF) and the Basic Commodities Supply-Side Intervention Facility (BACOSSI).This product directly competes with Banks who are supposed to lend to the same clients and earn sufficient interest income to keep the banks afloat. In reality a bank can not match this rate being offered by the RBZ, which has now been converted to a massive commercial bank. The only difference being it can lend money on a non-commercial basis with a net effect of taking the bread out of the commercial banks mouth.

Below is a general description how the forex market should work .The forex market has various transactions including spot, forward and swaps. A spot transaction is an immediate delivery transaction. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. Spot has the largest share by volume in FX transactions among all instruments.

A forex forward contract is an agreement between two parties to buy or sell a currency at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on US$ or Z$).Its use broaden and deepen the forex market since participants will have more option to satisfy their forex needs.

One party agrees (obligated) to sell, the other to buy, for a forward price agreed in advance. In some forward transactions, no actual cash changes hands. If the transaction is collateralized, exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise no forex of any kind actually changes hands, until the maturity of the contract.( but a commitment fee maybe payable upfront).This secures the forex. These contracts are legally enforceable. Its therefore important to have a strong and independent judiciary system which allows both parties to enforce their rights. The presence as in Zimbabwe’s case of a participant who appears above the law or who can unilaterally shift contract goal posts undermines these critical financial instruments.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the forex changes hands (on the spot date, usually within two business days). The difference between the spot and the forward price is the forward premium or forward discount. In Zimbabwe’s case the premium would then reflect the scarcity of forex plus the forex rate uncertainty and market volatility.

Forward contracts are personalized between parties ( but can be sold or ceded). The forward market is a general term used to describe the informal market by which these contracts are entered into. In Zimbabwe this would involve a financial institution and an exporter or an importer. This would allow the bank or the exporter to plan with some certainty about a future cash flow. This stabilised the market. The premium which now is openly a black market rate would legally and correctly be incorporated as the premium for committing to rates upfront. Standardized forward contracts are called futures contracts and traded on a futures exchange.

In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. This allows parties to swap say Zim dollars today and exchange the amounts at an agreed date. This allowed participants to legally lend each other foreign currency. This involved most financial institutions including the Central Bank which was probably the biggest player and beneficiary.

Zimbabwe has always needed outside forex for it balance of payment support. This came from various sources including donors,aid,direct foreign investment, supra-national organisations such as world bank,IFC and exports. These started to dry up about 8 years ago .As forex became more scarce the black market developed. The Banking industry responded with various products that included forward contracts, swaps and other forex linked derivatives. This allowed industry to access the at market determined rates.This is so because derivatives allow a premium or discount to factor in the scarcity, the volatility and the uncertainty. Using such instruments the banking system was able to efficiently allocate the scarce resource without letting the exchange rate get out of control. This way the market remained more formalised as banks acted as agents of the RBZ and the RBZ didn’t have to directly release trillions directly to its runners.

Prior to December 2003 this was the norm. The market players would transact at the going market rates as determined by the forward, swap and other derivative market instruments. These instruments were critical in the price discovery process as they factored most of the known risk variables .This kept the market reasonably stable and allowed RBZ, government and industry to orderly access whatever forex available. Then suddenly in December 2003 the biggest player in the market decided to unilaterally change pre-agreed rates in all forward, swap and other derivative contracts it had obligations .

This spelt a disaster for the sector. This is so because even if an institution was not a direct participant in the forward or swap contracts if it had exposure to any player who had a contract that was unilaterally re-priced that spelt enough trouble to cause panic which would then trigger a bank run when coupled with other factors. The unilateral re-pricing of contracts ( i.e. changing exchange rates pre-agreed) was and is ruinous to who ever is holding the contract .In short this meant certain institutions were unable to pay for their obligations as their expected cash flow from forward, swap and other derivative contracts were dramatically reduced by the key participant in the forex market.

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped. Swaps can be used to hedge certain risks such as interest rate risk and exchange rate risk plus the future availability of forex.In the Zimbabwean case this would involve swapping forex for Zim dollars ,with the understanding that at maturity this would be reversed. Obviously should the other party choose to unilaterally change the swap currency or transaction terms then other market participants would be exposed to ruin.

Currency swaps can be negotiated for a variety of maturities up 25 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by many accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract. This allows market participants to lend each other and carry out their normal economic activity using such products . Currency swaps involve the exchange of the principal amount. Interest payments are not netted (as they are in interest rate swaps) because they are denominated in different currencies.

Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies "shop" for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency. Zimbabwean companies have been excluded from such markets because of the country’s risk profile. The involvement of an interest and currency swap in one transaction allows the participants to accurately price the risk and reward who ever is providing the commodity being traded in this instance the exporter would be fairly rewarded whilst the importer can plan with certainty that they will be able to import their raw materials. This kept production systems on tracks and allowed the formal economy to function.

It is clear banks have been left with no option but to improvise to remain afloat. They deserve credit for that. They cant make loans out as the clients have a greater risk of default due to hostile environment. In addition the central bank has forex runners who by-pass the banks. They cant trade in forex as this has all been centralised and generally monopolised to such an extent its now a preserve of the central bank. This indicates the need to look beyond individual banks but rather the whole operating environment, regulations and various policy shifts which happen so constantly such that its almost impossible to assess their benefits. The central bank is now competing with the banks and as such banks have been crowded out of the traditional areas such as provision of market determined loans and forex transactions. Instead of being the lender of last resort the RBZ has become the lender of first choice. This is partially responsible for eroding the confidence in the banking system and undermining the sector. It may be time to amend the Banking Act to enable banks to ride the crisis .

Gilbert Muponda is a Zimbabwe-born entrepreneur, living in exile. He can be contacted at gilbert@gilbertmuponda.com

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