When Dr. Addision’s administration at the Bank of Ghana commenced with their plans to force Ghanaian banks to increase their equity whether or not their business model supported such an expansion or not, some of us argued vehemently against it.

We argued that this decision to force banks to expand even if they were not in a segment of the market that will support such forced growth was dangerous.

Dr Addision ignored his critics and told bank owners to go and find money and ensure that the amount of money they have invested overall in the bank was at least $84 or pack their bags and leave. Before then, folks who wanted to own a bank in Ghana only had to leverage $24 million of their own money.

His argument was that big banks are safer and more useful for Ghana’s economy. This was of course palpably untrue since Unibank was a very big bank. It ranked among Ghana’s seven largest banks consecutively.

Not surprisingly, when the troubles came, its failure had the worst impact on the financial sector, requiring $1.5 billion to plug the capital deficit hole it left behind.

Capital Bank and UT were bigger than Bank of Baroda and Sahel Sahara, and yet it was the former and not the latter that have cost the Ghanaian taxpayers large amounts of money following their collapse. There is absolutely no basis to the logic that size corresponds to bank stability.

In our opposing arguments, we pointed to countries like the UAE and Mauritius where minimum capital are $14 million and $6 million respectively, and yet with thriving financial sectors.

Countries like Nigeria that underwent the same forced recapitalisation introduced to Ghana have continued to see big banks fail. Many of the contrived creations that emerged as a result of the forced capitalisation “reforms” in Nigeria have been shown in recent acid tests to suffer from severe “capital adequacy” (NOT “minimum equity”) deficiency. Among these banks, Skye has already collapsed, and Diamond is being managed for acquisition.

The banks that were doing well before the recapitalisation – like Zenith, GT and Access – are, in the face of reduced competition, doing even better to the joy of their shareholders. But the Nigerian finance sector as a whole continues to remain largely unresponsive to the needs of the business community.

The country has one of the lowest digital finance penetration among Africa’s big economies. Its mobile money penetration is less than 2%. Compare this to Kenya’s, at 70%, even though the East African country has a minimum capital requirement of $12 million, because Parliament, sensibly, refused to agree to attempts by the Kenyan Central Bank to increase minimum capital to $50 million.

Today, Kenya’s banking sector has an average “return on equity” of nearly 25% (up from the 14% prevailing at the time of the attempted forced recapitalisation) compared to less than 16% for Nigeria.

We have been quite persistent in trying to get people to stop confusing “capital adequacy” (whether a bank has the capacity to manage its financial risks, absorb shocks, and meet its liabilities) with “minimum capital” (whether a bank is big enough). We have tried to explain that capital adequacy is far more important globally, and, judging by our history, in Ghana too. “Bigness” is a useless criterion in judging whether a bank is well run, moderating its risk appetite, making good profits and giving out loans that are likely to be paid back on time.

The real problem in Ghana has been that weaknesses in regulation and poor research capacity have made it difficult to assess whether banks are actually being well run, taking sensible risks and giving out profitable loans.

We have spent a lot of time copying and pasting ideas from the so called “Basel process” that need a lot of “localisation” before they can improve our regulatory situation.

On paper, many of the “global standards” being promoted in this whole Basel process and even in IFRS 9 (which is supplanting IAS 39 as a global source of guidance for accounting procedures at banks) are already being adhered to by Ghanaian banks, but in practice there is a lot of fudging and evasion. “More standards and rules” are not what would address this fudging and evasion. More skills and clever implementation and supervision, however, would.

Some commentators in support of the governor argued that we need big banks because they will then invest bigger amounts in the economy, so closing small banks down is the way to do that. Strange logic of this nature was usually coated in a lot of jargon, but carefully analysed they are wholly meaningless.

If you have 100 banks and they have 10,000 GHS each to lend, the total amount available for credit is 1 million GHS. If, on the other hand, you have 5 banks and they have 100,000 each, that’s 500,000 GHS. The latter situation is clearly not necessarily better for investment. Nothing stops small banks from “syndicating” to tackle big transactions. Even the biggest European and American banks do it all the time, for even relatively small projects, because syndication reduces risks.

Nor is the argument that Ghana has “too many banks” any more sensible than the others. There are many small economies around the world that have many banks, playing in different niches. And the same is true of big economies.

So whilst Canada, for instance, has only 91 schedule I, II, and III banks, it also has 2000 “savings mutual” banks with a wholly different focus.

Switzerland has 260 banks, only four of which are big by global standards. Many others focus on wealth management for clients with very specialised needs; some are cantonal-based and cater to SMEs; and yet more others prefer to specialise in trading.

Here in Africa, Egypt has 40 banks, but only five are large by continental standards, and they control half the market.  Of Kenya’s 44 banks, seven are truly big banks, dominating 80% of the market, yet the intense competition from the niche players keep them on their toes, injecting much dynamism in the sector.

Stripped of its jargon, the so-called minimum capital requirement was a logically deficient approach from the start, and was wholly unnecessary.

True, some banks had serious governance issues and had to go. We applaud Dr. Addision and the new administration of the Bank of Ghana for seeing this and acting in a determined fashion to address the problems. But as we have already shown, both big and small banks can be dubiously managed, so the process should have continued to focus on governance and solvency without the distraction of minimum equity.

As the Akans say, what the termites have chewed is already chewed; what needs protection is what is left behind. So we are where we are. The recapitalisation has been shown for the sham it is. The Bank of Ghana could only be bold up to a point. After the market proved to the regulator that it knows more than he does and refused to inject capital to inflate banks just because he says so, even when the economic opportunities for banking today does not warrant such expansion, the Bank of Ghana hurriedly came up with a compromise where Government will try to seduce or arm-twist the same market that has refused to pump more money into banks because they don’t see the opportunities for immediate expansion.This is what led to GAT.

I grudgingly admit that the GAT model was clever. But “clever” in a “twisted genius” kind of way.

The question however is: will GAT do more harm than good, or will it be neutral in its effect?

At the outset we must point out that because the artificial inflation of bank sizes is itself a bad idea, because it is not in line with clear market needs, if GAT succeeds it will only be providing steroids to keep a bad idea afloat. But this would not be a problem with GAT itself, and by reducing uncertainty, it may ameliorate the harshness of the recapitalisation directive on the locally owned banks, and by extension the broader industry, which cannot be a bad thing.

The only serious question then is whether GAT shall be handing out poisoned chalices to the remaining locally owned banks who could not convince sceptical investors to pump in more money to artificially inflate them.

Would GAT money affect their competitiveness and business models and thereby create more problems down the line for the financial sector as a whole even as reduced competition lead to windfall profits for the few shareholders of survivor banks?

That question can be addressed by focus on a single variable: “cost of funds”. Will GAT increase the cost of capital for the “beneficiary” banks? If it does, then those banks shall become less profitable, and start to weigh down major portions of the industry.

In this blogpost, we have decided to investigate this by focusing on one bank – UMB. UMB is one of the five beneficiary banks in the yet to be completed GAT strategy.

It currently has just a little above half of the $84 million equity that the Bank of Ghana, in their high and mighty wisdom, says they need to be considered a decently sized bank in Ghana and allowed to continue to operate.

It costs UMB about $38 million to raise the funds, including from depositors, it needs in a year to respond to opportunities it sees in the market (i.e. est. 2018 “interest expense”). With these funds in hand, it generates about $87 million in income from its borrowers and other market counterparties. After taking care of the various other costs of operations, it is left with about $16 million of total profit.

To strengthen its solvency, and likely also as a reaction to the ongoing liquidity challenges in the broader market, UMB has in fact been reducing both its loan portfolio and its depositor base. Between 2017 and 2018, deposits declined by nearly 5% (this is in stock terms; in flow terms, the decline amounted to about $53 million) whilst lending retracted by about 6.5%. At the same time that UMB has been reducing its liabilities and reining in credit growth, its profitability has been growing commendably (20%-plus in 2018 over 2017 levels).

The sudden injection of between $45 million and $50 million of equity into UMB would require a rethinking of this increasing conservatism and focus on profitability. Here, briefly, is why.

As explained in my previous blogpost, GAT seeks to borrow money from pension funds (all the “corporate bond” talk comes to this in the end) to invest in the likes of UMB. For GAT itself to be sustainable it would need to add on its margin in the on-lending transaction. GAT would then own shares in UMB and the other banks, and would be reliant on dividends paid by these banks to service the loans it would have taken from the Pension Funds.

The simple question then is: should UMB receive $50 million of the GAT money, would it be able to: a) generate the cashflows needed to pay GAT regular dividends so that GAT, in turn, can service its debts to the pension funds; and b) would the size of the dividends be sufficient for GAT to fully settle the debts as they come due?

In the simplest of terms, GAT has a “required rate of return” for the $50 million it shall be investing in UMB. In my previous blogpost I floated the figure of 32%. If that was to be correct, it would mean that UMB needs to be paying GAT $16 million in returns every year for the transaction to make sense (considering that GAT needs to start paying the coupons on the corporate bond as soon as the proceeds are realised).

Because equity is a residual claim, dividends are paid after interest and tax. In 2018, UMB was on course to make about $12 million after tax. The question this crude analysis prompts is whether an injection of $50 million into UMB shall raise the absolute quantity of profits the Bank makes to the sum needed to pay GAT a reasonable return, whilst keeping existing shareholders happy. That’s the question.

UMB’s recent-historical return on equity of about 18.5% give us an idea of its capital efficiency. Should shareholder funds increase, as a result of GAT investment, to $100 million, we expect absolute returns to hit about $18 million. For that to happen, however, UMB would need to reverse current strategy and aggressively expand credit again, which means more deposit mobilisation as the $50 million injection adds less than 10% to the Bank’s existing asset base. To appreciate this carefully, note that UMB has deposits of about $340 million and has given out loans to businesses and the government totaling about $400 million.

So it is not the injection of equity itself that leads to credit expansion directly, it is the need to pay back investors which does so by requiring that the Bank creates more assets out of more liabilities in the search for higher profits. This is at the heart of the leverage equation that drives banks. Understanding this diligently puts paid to the nonsense that recapitalisation on its own can expand credit available in the economy. Recapitalisation simply forces banks to expand, but the resources for the expansion must still be found within the economy.

This point is best driven home by putting the concrete results of the recapitalisation directive into perspective. By the time the exercise concludes, assuming all goes well with GAT, about $750 million would have been attracted into the banking sector in total. This is a sector that already has an asset base of $20 billion. The concrete impact of recapitalisation is thus the less than 5% increase in resources available for credit expansion (even when one ignores the reserve requirements). And yet the impact in terms of uncertainty and dislocations has been outsized.

But back to UMB’s cost of capital issues. As a 50% shareholder, and assuming no retention of profit for further investment, unencumbered cashflows available to GAT from UMB post-investment shall be in the region of $9 million. The clear conclusion then is that at any hurdle rate above 18%, the marriage between GAT and UMB begins to look very shaky, even untenable.

Of course, in practice, things are even less rosy. UMB has not paid a dividend for three consecutive years as the new management are still cleaning up the losses accumulated by the old managers (the bank’s income deficit is currently at $21 million, and this amount would have to be paid off before GAT will see a pesewa). In essence, UMB would need a three-year breathing period after GAT’s investment to start contributing to GAT’s liquidity pool for servicing the corporate bond sold to the pension funds. A corporate bond, like what GAT aims to issue, thus represents a mismatch between time-sensitive needs and payback dynamics.

But lowering GAT’s expectations from 32% to an 18% required return benchmark means that GAT must convince the pension funds to accept a yield of 15% on the planned corporate bond at a time when the risk-free Government of Ghana two-year note is generating 19.75%, implying that the one-year note, when available, should yield about 17.5%. In simple terms, the pension funds can buy safer Government debt at nearly the same rate that GAT is offering. This is clearly a no-deal situation. Any rate below 27% (a spread lower than the current prime – tier two benchmark within the Ghanaian financial industry today, mind you) for such a risky venture seems therefore unlikely to fly in the funds management industry.

Any rate above 20% passed through GAT to the beneficiary banks would, however, be highly problematic in a banking industry with a 16% average return on equity. A mighty gulf has thus opened between the participants in this three-way transaction.

What this crude analysis has sought to demonstrate is the hard negotiations between GAT, on the one hand, and the pension funds and beneficiary banks, on the other hand, that lie ahead.

We could of course have opted to calculate the weighted average cost of capital for UMB, held the cost of debt constant, and shown the impact of a 100% expansion of equity on this weighted average by varying the GAT discount rate on that equity portion (see figure below). Whilst the rigour would certainly have been appreciated by the professionals reading this blog, we would have lost 95% of the audience.

In the circumstances, we believe that this elementary analysis is a reasonable compromise to assist the main objective: show that GAT, as presently designed, cannot address the problems bequeathed by the poorly thought through minimum capital directive, unless it becomes sovereign-backed. Such a move would however impact on Ghana’s sovereign credit rating thereby undoing the cleverness of GAT in its “twisted genius” attempt to deflect the burden of paying for the Bank of Ghana’s misguided recapitalisation policy to the private sector.

That the targeted pensions industry is a part of the private sector that rides on mandatory social pensions contributions has also not been lost on observers.