Saturday, May 19, 2012

Why did the Nigeria capital market collapse?

By Olu Akanmu

            “…Markets rely on rules and laws, but those rules and laws in turn depend on truth and  trust. Conceal the truth or erode trust and the game becomes so unreliable that no one will want to play. The market will empty and share prices will collapse, as ordinary people find other places to put their money-into their houses, maybe, or under their beds…”
                    - Charles Handy (2002)

If we are not careful, the presentations and discussions at the House of Representative Committee investigating the collapse of the capital market, could degenerate into who had a better cosmetic between the leadership of the Stock Exchange and the Security and Exchange Commission. The newspaper commentaries even by leading opinion leaders give cause for concern. The issues are not that of two women or their fury. The issues are about markets, its fundamentals, the principle or theory that markets on the long run are wise- the efficient market hypothesis. The issues are about shareholders as corporate principals and their directors/ managers as their agents and how to ensure that these agents will act in the best interest of their principal. It is about public trust and expected morality of market players and our market institutions including auditors who report on companies and the trust placed in those auditing information by the ordinary investor who is taking investment decisions. Professor Soludo’s (former Governor of the Central Bank) presentation has hopefully been timely to raise the broader and fundamental issues that the house committee should face. The House Committee if it would do a good job must raise itself about politics of personal vendetta and act like a committee of true statesmen as would obtain in a US Congressional Committee sitting on similar issues. In this essay, we present some of the bigger issues that the House Committee needs to address on the collapse of the capital market.

There must be something fundamentally wrong with an economy or a market that values the service sector like banking more than the real economy where hard tangible goods are produced. How could the valuation of the banking sector have gone up astronomically when the real economy and its tangible product manufacturing companies were barely managing to survive, unable to produce because of power, lack of financing and shrinking consumer demand? What do banks bank? Banks bank the value created in the real sector. If economic value in the real sector was collapsing as we have seen in the last four years, how could the banking sector realistically be creating profit? What tangible real value would be behind those profits and the astronomical valuation of financial institutions at the peak of the stock market? The profits of the banking sector and their valuation should reflect the fundamentals of the businesses they bank and the economy where their customers operate. We had an asset bubble fuelled by margin loans, our collective greed and a weak regulatory framework that allowed market players to game the system and selectively drive up share prices of their firms without recourse to business fundamentals. Would anyone for example say that a price-earning ratio of more than 50 for insurance companies at the peak of the market was real, at least with the benefit of hind-sight? The essence of Professor Soludo’s presentation is that on the long run, a market would be wise and reflect the fundamentals of an economy and its competitiveness. Those who gained from short term market imperfections by clever arbitrage might have assumed that the short-run is the fundamental and expect their unrealistic gain to continue forever. Markets however do not work as such. They correct themselves and punish severely those who are caught when bubbles inevitably burst.

The economic questions for the committee should be how do we minimize potential asset bubbles and their long run consequences on investment and business confidence? How do we make the inevitable cycles of market bulls and bears less volatile, more predictable such that we can contain systemic market risk? How do we strengthen market oversight and co-ordinate regulations across financial markets from the real economy, banking and our asset markets such as the stock exchange and the real estate markets? How do we ensure that the economy rewards truly those who create economic value and not those who create paper profits which inevitably will lead to asset bubbles? How do we strengthen the incentive for real enterprise as against financial market arbitrage? There were many real economy entrepreneurs who took money out of their business where small but gradual economic value was being created to play in the capital markets. These entrepreneurs began to look “not too smart” compared to their peers playing "kalokalo” on the stock market. And many of them lost their investment in the stock market along with their business. The economy however lost more because jobs were lost, employment shrunk along with consumer demand which would have kept our factories running and kept even many more Nigerians employed.

With an open mind, the committee should acknowledge the gains of improved and coordinated regulatory framework in the last two years. Yet, we should also look at whether there could have been less costly ways to detonate the market implosion that we had at the peak of the stock market, situating the actions of our regulators within the weakness of our political, economic and legal institutions. The committee should also address the much over-flogged issue of corporate governance from the perspective of progress in the implementation of the governance framework proposed by the regulatory authorities. What has been the gain in the last two years in the art of governing our public companies? Are there any potential loop-holes emerging even in the context of current governance frame-work which could potentially lead to future crisis? Are corporations devising clever and legal ways around the values and principles that directors and managers must be true agents of their real principal who are their shareholders and represent only their interest? Does current compensation system of managers in the financial institutions encourage excessive short term risk for profit without adequate consideration for crystallizing of long term risk which impacts long term shareholder value? Do managers have adequate incentives to look at the real long term consequence of their managerial decisions if they are paid bonuses only for today when the consequence of their risk decision may crystallize later in the future when they would have moved out of the institution? How could we better tie the compensation of managers of financial institutions to the long term consequence of their decisions on shareholder value?

The committee may also want to invite the accounting profession to share its own learning and lessons with the people of Nigeria. The accounting auditing profession failed the investing public especially the ordinary investor who trusted their financial reports and took investment and risk decisions on their basis. Yes, there were accounting standard issues which will now be corrected with the new IFRS reporting standard. However, even within the context of the old standards, were there things in auditing that could have been done better? The issues of morality and markets, ethics and the value system of market players must also be discussed. At the peak of the capital market and its asset bubble, morals became separated from the market. Our market players had very little appreciation of their privileged public trust and acted largely with impunity, compromising and capturing the institutions that should regulate them.

In conclusion, perhaps the House of Representatives committee may want to reframe the question it seeks to answer. Perhaps the capital market did not really collapse but it corrected itself of its fundamental distortions and its "irrational exuberance". A market with a banking system that makes more money out of short-term financial arbitrage than lending to the real sector will not have sufficient incentive to lend to the real economy. When such banking system is saddled with real bad loans and eroded capital, it becomes a double jeopardy as it will engage itself in desperate profit creation and excessive risk to paper-over its underlying fundamentals. If such banking system now operates within the context of an economy that is increasingly loosing competitiveness due to poor infrastructure, financing, skill shortages , stagnating consumer demand and depleted external reserves, yet its stock market indices were suggesting an otherwise buoyant economy, something soon had to give way. Markets may look foolish in the short term but on the long run, they see through and they tend to be wise.

Olu Akanmu, a company executive publishes a blog on ‘Strategy and Public Policy’ on   . (For a more detailed discussion on what went wrong with the Nigeria financial system, readers may refer to the essay “Rebuilding Trust in the Financial System” on my blog   . You may use the label "Rebuilding Trust in the Financial System" or click further down on "older posts"