Understanding the changing capital requirement in the microfinance industry

Operators in the microfinance industry recently woke up to the news of an increase in the capital base of the different categories of microfinance banks in the country. The news was conveyed through a circular issued by the apex bank – the CBN. While the directive came with all the shock that naturally attends such regulatory actions, it cannot be said to be totally unexpected. Everyone saw it coming. Perhaps, the only surprise in it was the magnitude of the increase. Over the past several months, there have been calls for the further protection and strengthening of the banking sector in general and the microfinance industry in particular. The calls were for some reform measures that should include, as of necessity, an upward review of the capital bases of the various categories of microfinance banks. The decision to review upwards, the capital base of the operators was finally conveyed in October, 2018. Considerably mixed reactions have since dogged the action. Weshall attempt here to bring out some facts that we believe will assist stakeholders in understanding the action of the apex bank, in this regard.

Prior to the recent review, the three categories of operators in the microfinance industry namely, the Unit, the State and the National licensees, had regulatory capital of N20million, N100million and N2billion, respectively. Much of these have been impaired by losses, given what we know about the Non-performing Loans of the sector. The new capital requirement for Unit MFB is N200million while State MFBs are required to have a capital base of N2billion. National MFBs will be capitalized to the tune of N5billion. Some of us may remember when the capital requirement for commercial banks was about N6million. Now you need N5billion to operate (rich people’s kind of money to operate poor people’s bank). Some are wondering why.

The normal trends in the discussion of higher capital bases for financial institutions have almost always hinged on two issues: the need to protect the industry in order to avoid financial crises of the types witnessed recently, not only in Nigeria but across the globe. The other angle to the debate is usually on the need to understand that higher capital base has some costs it imposes on the financial sector and its stakeholders. For one, banks are likely to cut down on lending while charging more for loans. They are also likely to reduce payments they make on deposits, as part of the necessary steps they could take to maintain an acceptable level of return on the larger capital base needed to be employed under such new capital regimes. In other words, there are the twin issues of a sectoral and general macroeconomic stability, on the one hand, and the economic costs arising from deteriorated lending conditions and other impacts on banking services occasioned by the capital increase, on the other. There is therefore a need to competently balance these effects, when considering hikes in bank capital. That job is not easy.

The importance of capital in the affairs of a financial institution has long been established. It is the shock absorber of the bank and comes handy to meet some of the liabilities in case of trouble. It is important to know however, that the capital requirement generated by market conditions and outcomes, differs from regulatory capital. This is also well embedded in the books on capital structures. Determining the amount of capital suitable for financial institutions is not a piece of cake. Economists have, over the years, been studying this problem. The basic model from which most research on capital structures depart is the Modigliani-Miller (M&M) model, developed in 1958, proposing that in a frictionless world of full employment, a firm’s capital structure does not affect its value.

The presence of varied degrees of risk among banks makes it somewhat unrealistic for them to have a common capital requirement. This probably one of the arguments, especially by the smaller operators, against uniform hikes in capital. However, it is not easy to compute the capital needs of banks on an individual basis. While certain factors tend to reduce market determined capital requirements, others tend to raise it. For instance, tax considerations tend to reduce market determined capital requirements while the expected costs of financial distress tend to raise the requirement. Also, transactions costs and asymmetric information problems may either raise or lower the capital to be held by a financial institution. Similarly, deposit insurance or safety-nets tend to shield bank creditors from the full consequences of the risks taken by their banks. This also tends to reduce market determined capital requirement for banks. Thus, regulatory capital requirement does not respond effectively to the perceived differences in the risks carried by individual banks. It is therefore difficult to set precise capital ratios that reflect bank risks.

Given the highly risky market of the MFBs and the state of health of many, the regulators have a good reason to enhance their capacity to withstand shocks, by raising their regulatory capital needs. A simple risk-based ratios may not solve the problem of reducing risk. First, the capital in the numerator of the ratio may not control for the incentive for moral hazards, which is hard to measure. Besides, the risk in the denominator (risk assets) is imprecise and hardly corresponds to actual risk inherent in the embedded facilities, and also may be subject to manipulation. In order to minimize bank risk, therefore, capital requirements are often set much higher than they would have been, if capital ratios were to be set at their precise levels.

One of the problems of setting high capital requirements, which operators may consider too high above their needs as some do in the present case, is that it may encourage more risk-taking (higher risk appetite, due to a kind of money illusion or wealth effect). This increases the risk of failure among operators. It has even been suggested that this kind of behaviour was one of the reasons at the root of the crash of 2008. On the other hand, very high capital requirements also tend to lead regulators astray and into the error of thinking that they could look away from the ball and be fine, because the large capital base would provide operators a good cushion against losses. They forget that the operators themselves may be in the same error, lowering their guards and demonstrating more financial rascality, when they perceive themselves as super capitalized. Regulators are therefore encouraged to be even more vigilant when banks are highly capitalized than when they are not, because that is when many of the Off Balance Sheet transactions that sink banks are likely to be procured. As for the increase in capital requirements, I believe it offers operators the needed tonic to be better grassroots bankers rather than the mimicry of commercial banks they tend to be.

EMEKA OSUJI