Regulations, when well-conceived and implemented, are almost always good for business. They tend to set a bar that institutionalizes best practices, and signals confidence to investors and consumers of services alike. Due to its obvious sensitivity, the financial services industry is one of the most regulated industries in Nigeria – and rightly so. The Central Bank of Nigeria (CBN) regulates the financial services sector, ensuring risk mitigation at various levels and maintaining the overall sanctity of the financial system. As the banking sector has increased its reliance on technology to provide financial services, the CBN has not missed a beat in bringing new Financial Technology (“FinTech”) players in the space within its regulatory ambit. However, in its fervor, the CBN may have been drawn into a frenzy of ‘over-regulation' with regard to this important subset.
The Banks and Other Financial Institutions Act (BOFIA) 2020 has extended the regulatory authority of the CBN to payment service providers – a category of licensed entities that use technical or technology infrastructure, software solutions or services for facilitating end-to-end electronic payments.1 The CBN has also, and without any apparent real-world applicability, effectively extended Capital Adequacy Ratio (CAR) requirements on these entities that neither give out credit nor hold depositors' funds. The result: dousing the growth of a sub-sector that should otherwise catalyze the potential in Nigeria's vast unbanked economy.
Capital Adequacy in ‘Simpler' Times
To avoid being unable to meet its customers' demands, and to evade systemic failures, deposit banks are not permitted to loan out all the sums placed with them. Loosely, the bank's Capital Adequacy refers to the reserves it has on hand to ultimately meet some level of customer calls in extreme situations. Capital Adequacy leverages as some sought of insurance to evade institutional failures; failures that may give rise to systemic failures like the type that occurred in 2008.
CAR is a tool used around the world to protect depositors from banks becoming aggressive lenders. The object is to ensure that in lending, caution is exhibited by placing a limit on depositors' fund that can be loaned out. CAR measures a bank's available capital, as a percentage of its risk-weighted credit exposures. Deposits loaned to borrowers are expected to be paid as and when due. However, matters will sometimes turn out differently than anticipated, giving rise to credit defaults. Financial institutions are therefore expected to keep aside some of their capital to protect, primarily, against credit risk. Otherwise, large loan losses by banks could wipe out their total equity, thus leading to bankruptcy and in turn, systemic failure. At macro level therefore, the CBN uses Capital Adequacy requirements to foster financial system stability. Per CBN Guidelines2, Capital Adequacy strengthens the resilience of Nigerian banks (indeed Banks around the world) by increasing the minimum requirement for high quality capital which can absorb losses on a going concern basis, and by requiring banks to build up additional capital buffers to cushion against future unexpected losses.
Why does Capital Adequacy Ratio Matter?
Due to their interdependence on one another, if one bank fails, it is likely to have a dangerous ripple effect. While effective due diligence and credit committee investigations can reduce default events, they can never completely eliminate them. CARs ensure the efficiency and stability of a nation's financial system by lowering the risk of banks becoming insolvent, regardless of their performance in terms of profitability. Indeed, Capital Adequacy may not have anything to do with profitability. An institution may be profitable and yet may not have maintained the specified CAR. It is almost akin to a company operating without the right cover of insurance.
With Financial institutions offering any kind of credit, there is always a need for the regulator to protect funds of depositors. The CBN does well to instill confidence in the financial system by ensuring that a part of such funds is available as a cushion to support losses. So, the capital specified to be maintained, must either be liquid or kept in a semi liquid form. This is necessary having regard to the purpose for which the capital is preserved. The point cannot however be overemphasised that requirement for Capital Adequacy is peculiar and relevant to institutions offering any type of credit using depositors' funds or other third-party funds.
Should Capital Adequacy Ratio be applied by the CBN to every entity operating in the financial space?
We have previously examined the overarching rationale behind Capital Adequacy; being, to ensure that the bank has sufficient liquidity, should the banks solvency be threatened by excess call made on it by the depositors. It is naturally puzzling, when this requirement is extended to Other Financial Institutions (“OFIs”); particularly FinTech companies who act as enablers, without consideration of the peculiar nature of their activities.
The financial services ecosystem has many actors. Some companies in the payment system are not created to give out credit, but to provide an underlying service. The failure of these companies to provide such service(s) will not result in failure of the financial system, either in the short or long term. Such failure can be adequately protected by a simple insurance policy. CBN therefore seems to have applied a heavy hand, in imposing a Capital Adequacy requirement on all companies operating within ‘financial services' irrespective of whether or not such companies are tailored to give out credit or hold depositors fund.
The example of CBN's Approved New License Categorization Requirements Consolidated 2021, is illustrative. This regulation requires Payment Terminal Service Providers (PTSPs) to deposit a refundable NGN 100million into an escrow account; the CBN Payment Service Provider (PSP) Share Capital Deposit Account. It must be noted that PTSPs supply banks and OFIs, with ATMs and POS devices and do not in any way hold depositors' money or give out credit. As such there is no reason the CBN should impose such an exorbitant amount on such companies to fulfil the Capital Adequacy Requirement.
To avoid making superfluous, or worse; harmful regulations, regulators must ensure that intended regulations have a purpose, and also the potential to achieve the purpose for which they are created. Regulations may be stringent but should never stifle the growth of business unless that is itself a manifestation of the policy intention. In this case, imposing Capital Adequacy requirements on all companies in the financial services sector, seems to hold potentially far more negative consequences than may have been intended. Many tech startups are nimble, without legacy capital investments to sustain such requirements. As such, their viability may be seriously jeopardized – with knock on effects on their institutional clientele, employees, etc. It is the writers' humble position, that the regulations under review be re-evaluated in light of this commentary.
1 With the combined reading of sections 61 (1) and 9 of BOFIA 2020, Other Financial Institutions (“OFIs”, and under which the payment service providers -FinTech companies- fall) are required to comply with the minimum paid-up share capital determined by the CBN.
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