South Africa was too some degree insulated from the international financial crisis in late 2007. Many economists believe that the international crisis was largely a consequence of liquidity and credit problems experienced by many businesses. This paper highlights the importance of credit as well as the types of credit offered at different stages in the economy. The theories reviewed included the Hyman Minsky’s theory and the 2/28 adjustable rate subprime mortgages theory. The analysis confirmed risks associated with credit within the economy.
In the South African context, it is quite evident that the following contributed effectively to lessen the negative impacts of this financial crisis:
Prevention of access credit: The National Credit Act, FICA, Company’s Act of 2008 will discussed with relation to its role in the economy.
Monitoring measures: Basel I and II: South Africa implements these policies and procedures for all financial institutions to achieve best practice.
Sound governance mechanisms: The importance of King Reporting and Code of Ethics for various associations will demonstrate the importance of transparent reporting and procedures that should be followed for best business practice.
It is concluded that sound monitory policies including monitoring and corporate governance improves sustainable financial management.
The global financial crisis was triggered in 2007 by the liquidity crisis in the United States of America (USA) banking system primarily as a consequence caused by the overvaluation of x assets (Demyank and Hasan, 2009). It is considered by many economists to be the worst financial crisis since the Great Depression (Ryan, 2008). Economies worldwide have since slowed as credit tightened and international trade declined.
The South African economy was not impacted to as large an extent as the USA. This report illustrates how the regulatory framework in South Africa buffered the impacts to the South African economy. South Africa as part of the post-apartheid era and its social and economic transformation towards democracy adopted, inter alia, various regulatory mechanisms to manage credit lending’s in the country. The banking system adopted is thus well regulated without compromising the country’s competiveness. The report will provide some details illustrating the impact of the banking system during the global financial crisis.
Studies have shown that the different forms of borrowing and lending (also known as Credit) have become one of the biggest and most important roles in consumer spending (Cynamon and Fazzari, 2008). Consumer spending, in turn is one of the largest drivers of the economy. Hence, it can be said that credit plays one of the most significant roles in recent times within the economy.
Furthermore, it has been established by many economists that when an economy is stable, investors tend to extrapolate the current stability out into the future. This caused increased risk taking and was one of the major catalyst for the global economic recession which began during the late 2007(Demyank and Hasan, 2009). South Africa, during the global period in fact proved to be an important stable emerging market resulting in additional benefits in terms of investments.
The paper will address the following questions:
- How important is credit in the economy?
- What type of credit is offered in the different stages of the economy?
- What monitoring and legal requirements does South Africa have in place?
- What are the various prevention measures that South Africa have in place?
The method adopted includes:
- A literature review of the cause and effects of the economic crisis in the United States of America (USA)
- A literature review of the South African banking regulatory framework in South Africa
- Identifying the factors in South Africa that offered the protection
- Conclusions to address the research question
The conclusion will identify whether the monitoring and prevention measures that are in place are effective and helped South Africa buffer the global economic crisis.
The remainder of the paper is sequenced as: Section 2 discusses the importance of credit in the economy, Section 3 investigates economic theory and credit, Sections 4 and 5 investigate monitoring and prevention measures implemented in South Africa. Finally, Section 6 discusses the findings and concludes the paper.
2: Importance of credit in the economy
Consumer spending and financial preferences has evolved with the transformation of social and economic norms. According to Barry Cynamon and Steven Fazzari (2008), consumers base their consumption norms on what others should or should not purchase. Their research shows that in current times, households use financial markets to heavily finance their expenditure. As most households make use of credit, actual consumption growth will exceed income growth.
Research done by Guiso, Sapienza and Zingales (2003; 2006) shows that religion is correlated with the attitude towards savings. Their findings indicated that variables reflecting culture are highly sensitive to cross country saving and expenditure ratios.
The high spending patterns of households that have developed in society has caused many consumers to over-debt themselves. The recent research conducted by Yuliya Demyank and Iftekhar Hasan (2009) shows that financial institutions in the USA were offering consumers mortgage loans for houses at levels far higher than the actual sale value. The main reason for this was that securitisation increased lending between 2001and 2006, which in turn lead to lower incentives for banks to screen the potential borrowers. The consequence of not screening borrowers before approving loans was high default rates.
The recent credit crisis in the United States of America USA was largely due consumers being over-indebted. Factors such as securitizsation (Mian and Sufi, 2008) and weakened monetary policy (Taylor, 2008) resulted in high consumer debt.
Some of the fixed income products offered to consumers include (CFA Institute-VOL 5, 2010):
- Asset backed securities (ABS)
- Mortgage backed securities (MBS) and
- Collateraliszed debt obligations (CDO’s)
Asset backed securities is a security created from a specific pool of collateraliszed assets. The pool of assets is a group of small illiquid assets that are unable to be sold separately (an example include credit sales). The mechanism of how this type of security is created is:
Initially, the seller of the goods issues the loan to the customer for the purchase of the goods. The loan is sold to a special purpose entity (SPE) created by the seller. The SPE will in turn repackage the loans into various tranches and issue these as notes into the market. In other words, the notes purchased by the investors are funding the loans issued by the seller through a conduit. The collateral which is given over the notes is the loan.
A mortgage backed security is a security created from a pool of one or more mortgage loans. The institution repackages the pool of securities and issues bond notes into the market and the collateral given over the bond is the pool of mortgages. The interest and principal received by the bond holder come directly from the repayment of the mortgage loan. The institution again, is merely a conduit through which the notes are issued to lenders and loans given to borrowers. The institute issues the loans at a high rate and the notes at a lower rate, thereby profiting through a spread.
Collateraliszed debt obligations (CDO’s) is a type of an asset backed security whose value and payments come from a portfolio of fixed income assets (mortgage loans and corporate bonds). These CDO’s are then split into different risk classes, whereby the most senior class will be the safest security. The interest payments are made based on the order of seniority. Therefore the lower seniority CDO’s will offer higher coupon payments or lower prices to compensate for additional default risk.
The various forms of fixed income products are essentially securities issued on illiquid assets that are made liquid.
3: Economic Theory and Credit
There are various theories which have been developed in assessing credit during a stable economy. Two of the most relevant theories include:
3.1: The Hyman Minsky theory:
Hyman Minsky’s “financial instability hypothesis” (Cynamon and Fazzari, 2008)
The Hyman Minsky theory involves three stages with credit:
3.1.1: Hedge Unit – This is the first stage within a stable growing economy. This stage of the cycle indicates that when loans are issued by lenders, lenders require credit worthy borrowers. In other words, lenders require borrowers whom are capable of repaying both the principal and interest portion of the debt timeously. At this stage in the cycle, financial institutions have policies and measures in place to hedge themselves when a loan is granted to a consumer.
3.1.2: Speculative Unit – Due to the rapid growth in the economy during the hedging unit stage, lenders become more confident in borrowers. This leads to the speculative unit stage of the economy. In this stage, loans issued are slightly more risky as loans are granted to borrowers who only have capacity to repay the interest portion of the loan each month. These loans are given with the assumption that at the maturity of the loan, the borrower will sell the property to repay the principal on the loan. In other words, a balloon repayment at the end of the loan terms is used to repay the principal loan. Borrowers incentiviszed to accept this type of loan as it has low premiums.
3.1.3: Ponzi Unit – During the speculative stage, the demand for property increases as the number of loans granted increase, resulting in the prices of property to increase. Lenders had assumed that this price increase would go on forever. Therefore, they had used this price increase of property to grant loans to borrowers where the borrower will repay the principal together with the interest in a single balloon payment at maturity upon the sale of the property.
However due to the borrower purchasing an already overpriced asset, the borrowers will speculate that the asset value will rise even further allowing the sale of the asset at an extremely high price. This did not occur as the prices of these assets began to rise so dramatically that the demand for the assets began to decline. This had in turn caused the prices of the assets to decrease. Upon repayment of the loan at the end agreement, the borrower was unable to repay the full interest and principal increasing the default rate.
Vercelli’s (2009) research has shown that the recent economic recession is largely correlated to Hyman Minsky’s cycles. When the Unites States of AmericaUSA’s economy was at a boom, it induced great increase in potential financial fragility. Financial fragility provides for a foundation for financial instability. This lead to the process decrease in debt and ultimately the great economic recession that has affected the world (Kregel, 2010). Research done by Kregel (2010) and Vercelli (2009) has shown that understanding the Minsky Model can be a vital tool for government to avoid an economic recession by placing certain policies in place.
Another example taken from the CFA Institute (VOL 5, 2010) is that during the initial speculative stage of the economic cycle, house prices were still rising. The mortgage industry then began granting free at-the-money call options to the borrower over the property. The manner in which this call option worked is as follows:
If the borrower continued to make the monthly payments, they were entitled to an at-the-money call option over the property. As the property value continued to increase, the default rates over the mortgages were low because the option was valuable to the borrower. However, as the property value began to decrease, as per the explanation given in the ponzi unit, this caused the intrinsic value of the option to render a nil value to the borrower. This had a knock on effect over the repayments of the loan, as borrowers now began defaulting over their repayments.
3. 2: The 2/28 adjustable rate subprime mortgages theory:
The 2/28 adjustable rate subprime mortgages (Penington-Cross and Ho, 2006)
The 2/28 adjustable rate subprime mortgage is a type of loan given to a borrower whereby the borrower does not give any security and the interest rates for the first two years are below market interest rates and are fixed. After two years have passed, the interest rate is adjusted by an average of five percentages (CFA Institute, 2010). During 2004 and 2006, most borrowers who were not credit worthy used this type of mortgage.
There were types of adjustable rate loans in the subprime but the most used was the 2/28 adjustable rate loan. These types of loans were issued by lenders to riskier clients. The reason that this loan was targeted to riskier clients was that the transaction costs were low and the borrower can easily get out of a loan contract as soon as possible. The manner in which the borrower backs out of the loan, is as follows:
At the end of the two year interest free period, the borrower will enter into a second subprime loan with a different financial institute. The borrower will then use this second loan to repay the first loan. In this manner, the borrower will continue to roll the high interest payments forward. (Penington-Cross and Ho, 2006).
4: Monitoring Measures implemented in South Africa
4.1: Basel I and II
The Basel Committee was created by an International committee for banking supervision and was adopted by the South African Reserve Bank in February 2005. This committee has formulated broad supervisory standards, guidelines and recommends statements of best practice. (Shaik-Peremanov, 2009). Some of the guidelines include greater disclosure within their financial statements thus making the banking industry more competitive, reporting of each banks credit risk to the Reserve Bank and greater segregation of duty to decrease the risk of errors and misstatements. The main objective of the Basel set by the board is to ensure minimum bank solvency margin of 99.9% over a one year horizon (Kupie, 2006).
There are three minimum standards/pillars within the Basel I and II (Shaik-Peremanov, 2009):
- Minimum capital requirements
- Sound management of capital
- Adequate disclosure of capital requirements and associated risks.
The minimum capital requirements: This deals with minimum capital requirements so that financial institutions are able to hedge themselves from credit risk, market risk and operational risk. The amount of each financial institution’s risks differs. Due to this difference, the formula for the estimation of minimum capital requirements can be easily re-designed to fit each institution (Kupiec, 2006).
The sound management of capital: This requires banks to make certain that minimum capital requirements are met at all times.
Adequate disclosure of capital requirements and associated risks: This standard deals with the correct and sufficient disclosure of the institutions capital requirements and the risks that they are exposed to. Research has shown that if correct and sufficient disclosure of information of banks, this would decrease investor confidence on other banks (Yamori, 1999). Yamori (1999) indicated that in developed countries, where there are sufficient disclosures, the likely hood of investors to re-evaluate their confidence in other banks is minimum compared to developing countries where adequate disclosure is not given to investors.
Some economists believe that there are large links between the Basel I and the recent economic crisis. Some of the criticism includes (Cannata and Quagliariello, 2009):
- The amount of minimum capital requirements estimated by the Basel I is inadequate and this was of the reasons for major banks to collapse.
- The use of fair value accounting has caused larges losses in the portfolios of the intermediaries.
- As the capital requirements of the Basel I are cyclical, many say that Basel I supports business cycles.
- There are large conflicts of interest within the banks as credit risk has got to be assessed by non-banking institutions such as rating agencies.
- The reliance on internal models to estimate risk exposures.
- There are incentives for special purpose entities to deconsolidate from the banks as they might have very risky exposures.
Cannata and Quagliariello (2009) also conclude that Basel had no links to the recent economic crisis and bank failures as it is not sensible to blame Basel because it did not prevent unregulated special purpose entities from excessive leverage and risk taking. It would be rather more appropriate to extent the scope of the Basel report to those special purpose entities.
In light of the short comings of Basel I, the Basel Committee has created a Basel II. This version tries to increase the correlation between risk and minimum capital (Onado, 2008) and correcting other short comings of Basel I.
One of the monitoring and calculation measures recommended by the Basel committee is Value at Risk, commonly known as VaR. VaR is used to calculate and controlling exposure to market risk. This essentially measures the volatility of the institutions assets such as debtors and other instruments. The higher the volatility, the greater the risk of an institution’s loss (Berkowitz and O’Brein, 2002).
VaR takes into account all adverse effects of risk exposures (such as interest rate risk, exchange rate risk, equity price risk, etc.) and it calculates the expected maximum loss of a portfolio caused by these risks. The estimate is dependent on a specified holding period, correlation of variables, volatility and confidence level (Rockafellar and Uryasev, 1999). The estimate increases as the holding period, confidence interval, correlation of assets and the volatility increases.
There are three methods of calculating VaR and they are (Linsmeier and Pearson, 2000):
- Historical Simulation
- Monte Carlo Simulation
The variance-covariance approach uses and relies on matrices to calculate VaR. The volatility and correlation of data in the matrix calculations involves using in-house or published data. The most important assumption used in this approach is that the returns on the assets in a portfolio are normally distributed.
The historical simulation uses actual historic data on returns of portfolio assets to calculate potential losses (Hendricks, 1996). One of the advantages of this approach is that it captures the abnormality of asset returns if present in the data. This approach is also very easy to implement as it is conceptually simple to use. One of the major disadvantages of historical simulation is that an assumption of what occurred in the past is a reflection of the future.
The Monte Carlo simulation involves simulating the random price behaviour of financial assets in a portfolio using the power of the computer. The advantage of this approach is that it is very flexible method as simulations can be altered. This approach however, is very capital intensive as it requires a number of computer simulations in order to obtain the required level of accuracy. This model is very time consuming as many financial institutions have a large compilation of portfolios and that is the reason why many banks do not use this model.
Some of the benefits of the VaR include (Linsmeier and Pearson, 2000):
- The simplicity of the end result and this can be easily communicated between all stakeholders,
- All risks associated with different instruments can be aggregated within a portfolio,
- It promotes more efficient allocation of resources by encouraging institutions to avoid over exposure from one source of risk,
- In a trading environment, VaR is important in determining performance evaluation,
- It helps market regulators to ensure that institutions do not liquidate.
The disadvantages of the VaR Model are (Linsmeier and Pearson, 2000):
- The assumption that many of the models are normally distributed which is incorrect as it does not capture unusual events,
- The assumption that historical data is a reliable guide to what will happen in the future,
- Some models are not suitable for portfolios containing certain types of financial instruments,
- There may be difficulties in capturing and reliability of data,
- The costs may in some cases overshadow benefits received from the models,
- Different methods can estimate different results on a daily basis and not always give a consistent estimate,
- The VaR tool is not in itself a tool for risk management but it forms part of a complete range of policies and procedures involved in decreasing a financial institutions risk.
Although there are flexibilities regarding the VaR model, Basel II has specified some minimum standards for the purpose of calculating capital requirements. These minimum standards include (Basel II Accord):
VaR must be computed every day,
A confidence interval of 99% must be used when calculating capital requirements,
The minimum holding period of 10 days should be used,
The minimum observation period should be one year, i.e. 250 trading days,
Financial institutions should update their data set at least every three months,
Banks are permitted to recognisze correlations within broad risk categories. Provided that the relevant supervisory authority is satisfied that the bank’s system for measuring correlations is effective and appropriate, they may also recognisze correlations across broad risk factor categories,
Banks internal models are required to accurately capture the unique risks associated with the options and option like instruments.
The South African Reserve Bank has made it a legal requirement for all companies within the financial services sector to comply with the Basel Report.
4.2: South African Reserve Bank Monetary Procedure
The reserve bank is one of the most important institutions created to control economic growth and fiscal stability in a country. It must be noted that the creation of a reserve bank has no guarantee against financial crisis (Bekink and Botha, 2008). Their early detection and timely fulfillments fulfilments of their duties have an important impact on the financial markets. A reduction in consumer bankruptcies, corporate failures and liquidations is a consequence of the reserve bank’s actions.
The other functions of the reserve bank are:
- Making loans to certain defined customers
- The custodian of cash reserves of all other banks
- Lending cash to banks when there is a shortage of liquidity.
The objective of the reserve bank is to protect the value of the currency in the interest of balanced and sustainable growth. The manipulation of the countries prime lending interest rate is used to achieve this objective.
Monetary policies are useful when the country intends to depress the demand for cash. This will usually occur during excessive consumer spending. In order to stimulate demand for cash during recession, the reserve bank would decrease interest rates. The manipulation of interest rates is vital as it has a direct impact on consumer spending and corporate viability (Kaseeram, 2010). Inflation can also be control with the monetary policy of the country as inflation erodes the real purchasing power of the consumer. There is a trade-off between inflation and consumer spending. To decrease inflation, the reserve bank increases interest rates and in turn causes consumer spending to contract.
5. Prevention Measures implemented in South Africa
Various preventative measures have been implemented in South Africa to prevent an economic crisis caused by credit.
5.1: National Credit Act (NCA)
The National Credit Act 34 of 2005 was one of the laws that government has legislated in order to achieve a number of objectives mostly for the benefit and protection of consumers (Mcdougall, 2009). It provides certain regulatory policies in order to achieve fair and non-discriminatory access to credit. The Act promotes responsible granting of credit and provides remedies in the case of consumers being over-indebted. Therefore credit providers are required not to be reckless as they might find that the contract may not be legally binding even though it might contradict common law.
The Act promotes responsible credit-granting practices by:
- Prohibiting reckless credit granting
- Provide for the general regulation of consumer credit and improved standards of consumer information
- Promote black economic empowerment and ownership within the consumer credit industry
- Provide for restructuring in cases of over –indebtedness
- Establishing national norms and standards resulting to consumer credit
- Establishing the National Credit Regulator
- Establishing the National Credit tribunal
This Act requires credit providers to disclose all information pertaining to the contract. Some of the information that has to be disclosed is:
- Hidden fees,
- Extra interest that will be required to pay in the case of late payment,
- Credit life insurance,
- Implications of special offers,
The National Credit Act now specifies that credit providers must give consumers a quotation or pre-agreement disclosure, which is valid for five working days, before that contract can be entered into. Within the quote or pre-agreement contract, the credit provider has to disclose all material items such as contract fees, interest rates, penalties and other fees pertaining to providing credit.
The Act has certain limitations such the exclusion of a juristic person, whose asset value or annual turnover equals or exceeds one million rand, and some believe it does not provide adequate protection (Narshi, 2009).
5.2: Financial Intelligence Centre Act (FICA)
FICA has been established to stop money laundering and terror financing in order for South Africa to protect the integrity and stability of the financial system. All financial institutions have to follow the policies, procedures and framework prescribed in the Act.
Research has shown that managerial efficiencies is one of the greater factors that contribute to the liquidation of banks. Managerial efficiencies is are caused mainly due to collusion within the firm to either money launder or not disclose material information to stakeholders (Wheelcock and Wilson, 2000). FICA combats this by obliging workers to report all unusual and suspicious transactions to the regulator.
FICA also prescribes that all financial institutions keep all records of client information and transactions available to the regulator. Financial institutions are required to update client information periodically.
In order to fulfill fulfil the objectives of the Act, the FICA centre collects all information regarding all statutory reporting obligations and analyses and interprets the data. The centre than uses this processed information to advise law enforcement bodies or/ and South African Revenue Services if performance from them is needed. This centre also promotes the use the appointment of bodies that specialiszes in measures to detect and count money laundering. By performing these transactions, the centre is also becoming one of South Africa’s repositories for financial transactions.
5.3: Company’s Act of 2008
The Company’s Act of 2008, which is still not effective, has many new amendments in place to remedy some of the draw backs of the current Act. The Act brings out mechanisms for rescuing businesses that are in financial distress. The aim is to ensure that companies are saved before they reach a stage of insolvency and liquidation. This will ensure efficiency and sustainability in the business industry.
Directors in the companies are required to follow the fiduciary duty described in the Act. The Act also contains minimum members on the board as well as the minimum amount and composition of committees with the board. Directors that are negligently ruuning running the business may be held personal liable for damages caused.
The Act has also a large focus on corporate governance and related issues. It requires all directors to disclosure all information pertaining to their income and responsibility.
5.4: Corporate Governance
The past decade has witnessed the evolution of corporate governance guidelines and codes (Barac and Moloi 2010). Many lessons have been learnt from corporate collapses throughout the world. These corporate failures have led to various attempts to strengthen corporate governance frameworks in order to bring about greater transparency and accountability to corporate affairs. Investor confidence is also increased with good corporate governance practices (Davies and Schiltzer, 2008). Some of the corporate governance guides include:
- King Report
- Code of Professional Conduct
- CFA Code of Conduct
The King 3 Report was created to complement the new Company’s Act’s governance (Barac and Moloi, 2010). The Johannesburg Stock Exchange (JSE) made it a requirement for all companies listed on the stock exchange to comply with the King 3 Report. The objective of the King Report is to meet and shape developments for businesses in society. King Report has evolved from 1994 to line itself with international trends. Since the implementation of the King Report, there has been a dramatic effect on business ethics and morality in South Africa (Jackson and Stent, 2010). Some of the rules are that companies should comply with the framework of the report and if a company departs from the King Report, they will be forced to explain their actions.
The Code of Professional Conduct created for members of the South African Institute of Chartered Accountants. This code establishes fundamental principles for which professional accountants must comply with. The principles are:
Integrity- Professionals should be honest, truthful and fair.
Objectivity- Professionals not exercise biasness when performing tasks for employers or clients.
Professional competence and due care- Professionals should always be up to date with their knowledge and act diligently in accordance with the relevant reporting standards.
Confidentiality- All information relating to clients and employers should remain confidential.
Professional behaviour- Professional Accountants should not act in a manner which may bring discredit to the profession.
This framework was created for all people with different ethical backgrounds and therefore the code does not have specific rules that accountants should follow when certain threats arise.
The Chartered Financial Analyst (CFA) Code of Ethics stipulates that all members and candidates must follow the code of conduct. Each candidate must (CFA Institute, VOL 1, 2010):
Act with integrity, diligence, competence, respect, and in an ethical manner with the public, clients, prospective clients, staff and other participants in the global capital market.
Place the integrity of the investment profession and the interests