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Capital requirement, bank competition and stability in Africa- Q&A Session

05.09.2017Jacob Oduor, Principal Research Economist, African Development Bank

This Q&A session highlights key insights of a study co-authored by Dr. Jacob Oduor, economist with African Development Bank. The research shows that increased capital beef-up significantly increases financial instability in Africa (except in big banks) implying that higher capital requirements did not make African banks safer.

1. Why did you choose a topic on the banking sector, precisely on regulation? Is there any subdued risk with African banking system that justifies your research?

The banking sector is important in driving economic growth through intermediation of investment resources. Its effectiveness in achieving this role can however be undermined by one-size-fit-all regulations. In Africa, where financial inclusion is still low, any regulation that increases the cost of financial services may be counterproductive in achieving the broader economic growth objectives. If increased capital requirements can achieve its core objective of financial stability without adversely affecting the cost of financial services, then it is welcome. That tradeoff is important but sometimes difficult to strike.

2. Basel I, Basel II and now Basel III have called for capital build-up over time. In your view, how will the latest reform affect African banks?

Capital build up has the consequence of creating bigger banks. There are two main problems with this. First, emerging evidence show that bigger banks are not necessarily safe. They perceive themselves to be "too big to fail" and therefore engage in more risky investments and are more vulnerable to shocks that smaller banks (Berger and Mester, 1997[1]) and such regulation may just as well increase banking sector instability in Africa. The second and more important consequence for Africa is that capital build-up concentrates the banking industry, reduces competition, has the potential to drive up costs of financial services and stifle financial inclusion. The high initial capital stringency requirements can impose entry barriers for new entrants and this would restrict competition and allow existing banks to accumulate market power (Berger et al; 1993[2]). In a continent where financial inclusion is pathetically low, such regulation may have more negative consequences than benefits.

3. Your research was centered on the impact of regulatory build-up on first financial sector stability and second competition. What did your research reveal?

The results show that increased capital beef-up significantly increases financial instability in Africa (except in big banks) implying that higher capital requirements did not make African banks safer. We also find that increased regulatory capital improves competitive pricing for foreign banks while it makes domestic banks less competitive. This is mainly attributed to the high cost of sourcing and holding extra capital for domestic banks compared to foreign banks who can source cheaper capital from parent companies. The results put to question the effectiveness of higher regulatory capital on stability and competitiveness of the African financial system.

4. Did you find in your literature review similar conclusions?

While other studies including Furlong and Keeley (1989)[3] and Keeley (1990)[4] found stabilizing effects of increased capital requirements, other studies have come to similar conclusions as our study. Boot and Greenbaum (1993)[5] for instance find that capital requirements reduce monitoring incentives, which reduces the quality of banks' portfolios increasing the risk of instability. Hakenes and Schnabel (2010)[6] on the other hand show that tighter capital requirements increases the risk of individual loans and may also increase a bank's probability of default because they relax the competition for loans and thus destabilizing the banking sector.

On increased capital requirements and competition, similar findings as ours were obtained by Bikker & Groeneveld (1998)[7] who assessed competitive structure in the banking industry in the EU and finds that concentration impairs competitiveness. Similar findings were also obtained by and Claessens and Laeven, 2004[8] among others.

5. In your research, you also test your model for reserve causality. What was the idea behind the test and what did the test show?

The potential for reverse causality emanates from the fact that banks that are viewed by the regulators to be less stable are likely to be asked to keep higher capital ratios compared to more stable banks. Instability may therefore be a cause of higher capital requirements for banks as much as higher capital requirements may be a source of instability. The results using instrumental variables approach, confirm the findings that increased capital ratio increases instability in the banking sector.

6. You mentioned that some critics argue that Basel III is too complex and allows banks to use in-house creative models to hold less capital than they should. Can you talk more about some of these techniques and how can regulators address the shortcoming? How will/should this be addressed in the context of the African continent?

Amendments to the Basel Accord in 1996 permitted regulators to accept assessments from banks' internal risk-management models in setting capital requirements for the market risk in banks' trading portfolios. Consequently, trading-book models have become increasingly common in banks. These models generally estimate value at risk (VaR). Because of the large number of traded securities, trading-book VaR models inevitably use a large number of simplifying assumptions resulting in different estimates of value at risk. It is therefore not inconceivable that some banks use these internal models to understate their risks in order to maintain less regulatory capital which exposes the whole sector to risks. To remedy such situation, regulators must ensure banks calculate their risk weightings and capital requirements on the basis of a common standardized approach. In-house models could be used to supplement but not substitute standard models. To reduce the ability of banks to hide risky assets there is need for reduced discretion of banks in calculating their risk weightings by narrowing the range of modeling choices for banks and improving public disclosure by banks. There is also need to explore regulation with varying standards based on complexity and risk.

7. In the US, the concept of "too big to fail" has emerged as a hot contentious topic between regulators, policy makers and banks. A debate between breaking up large banks or at the very least the reinstatement of some Glass-Steagall-like legislation and the status quo. You cite the example of Nigeria as evidence that consolidation is not the answer to the banking system stability. Do you see any systemic risk associated with the size of the banks operating in our continent? Have some of them reached that critical level?

While this study did not go into establishing the specific threshold beyond which inefficiency sets in, experience has shown that big banks can fail and there is a threshold size beyond which decreasing marginal returns sets in. Attempting to build resilience through indefinite increase in capital requirements may be counterproductive. In addition, capital buffers on their own without accompanying regulations are at best, inadequate. Regulation must therefore look beyond the size of the banks. Market concentration in the banking industry in Africa is high compared to the developed world and therefore the potential for systemic risk exists, but whether some African banks have reached that threshold is an area for further research. What is clear from our results is that prescriptive blanket regulations on capital buffers has not helped reduce that risk. Dealing with systemic risk should not therefore overemphasize on size, but accompanying regulations to ensure good governance and prudent risk taking irrespective of the size.

8. If capital build-up is not the answer to increase financial sector stability, what types of policy should regulators and policy makers pursue/explore in their quest for a strong, deep and liquid financial sector?

Capital build up is still important in building resilience, but it is not the only way to build resilience, not in all contexts and on its own it is inadequate. Regulators must be able to identify the sources of systemic risks and develop regulatory instruments that are able to deal with different kinds of risks. Internal governance weaknesses is turning out to be a major source of instability in the banking sector in many countries both in Africa and in more developed markets. This kind of risk cannot be cured by increasing capital buffers. Improvements in monitoring and supervision of banks may as well give the same financial stability outcome without jeopardizing financing inclusion objectives.

9. What is your opinion on the emerging rivalry between fintechs and banks and do you see this as an inevitable event to improve efficiency and increase inclusion? From the regulatory stand-point, what if need be, can be improved?

Without a doubt, fintechs have disrupted the business-as-usual way of traditional banks and helped improve financial access and efficiency beyond the boundaries that traditional banks were willing to go. From mobile money payment and transfer services, to savings and credit services through the mobile phone platforms, fintechs have proved to the banks that your can reach the low-income unbanked and still make profits. Banks are increasingly adopting the same approaches to delivery financial services in order to stay in business. However, in some instances, the pace of adoption of new technologies in the financial sector is faster than regulations. A number of regulators have not developed tools and infrastructure including state of the art reporting and analytics infrastructure to support and sufficiently regulate the fintech innovations. In most cases, fintech companies are discouraged by the time and cost of registering and complying with regulations. This is a particular problematic in the financial services sector in Africa where political interests are still intense and where intruders coming to share the profits are not welcome. In addition, regulations should be flexible and fintech companies should not be forced into the same costly regulatory mold as traditional banks, which may stifle innovative capacity of start-ups.

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[1] Berger, A. N. & L. J. Mester. 1997. Inside the black box: What Explains Differences in The Efficiencies of Financial Institutions? Journal of Banking & Finance, Vol. 21, pp. 895-947

[2] Berger A. N., W. Hunter, and S. Timme. 1993. The Efficiency of Financial Institutions: A Review and Preview of Research Past, Present, and Future, Journal of Banking and Finance, Vol.17 pp. 221-249

[3] Furlong, F. T. and M. C. Keeley. 1989. Capital Regulation and Bank Risk-Taking: A Note, Journal of Banking and Finance 13, 883-891.

[4] Keeley, M. C. 1990. Deposit Insurance, Risk and Market Power in Banking, American Economic Review, Vol. 80(5), pp. 1183-1200

[5] Boot, A.W., and S. Greenbaum. 1993. Bank Regulation, Reputation, and Rents: Theory and Policy Implications. In: Mayer, C., and Vives, X. (eds), Capital Markets andFinancial Intermediation. Cambridge, UK: Cambridge University Press, 292-318.

[6] Hakenes, H. and I. Schnabel. 2010. Capital Regulation, Bank Competition, and Financial Stability, Leibniz University of Hannover, MPI Bonn, and CEPR

[7] Bikker J.A. and J.M. Groeneveld. 1998. Competition and Concentration in the EU Banking Industry Research Series Supervision 8, Netherlands Central Bank, Directorate Supervision

[8] Claessens, Stijn, and Luc Laeven. 2004. What Drives Bank Competition? Some International Evidence. Journal of Money, Credit, and BankingVol. 36, pp. 563-583

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About the Author

Dr. Jacob Oduor is Principal Research Economist at African Development Bank (AfDB). He is a holder of Ph.D in Economics from Bielefeld University, Germany. He is also a holder of MA (Economics) and BA (Economics)- First Class Honours from Kenyatta University, Nairobi, Kenya. Prior to joining AfDB, Dr. Oduor lectured in the School of Economics at Kenyatta University and he worked with the Cooperative Bank of Kenya and the Kenya Institute for Public Policy Research and Analysis (KIPPRA). Dr. Oduor is an accomplished time series econometrician specialized in: time series, cointegration, general macroeconomic theory and policy, monetary policy and growth theory.

Pension funds can play a pivotal role in African aspirations for 2063

19.06.2017Gerald Gondo, Business Development Executive, RisCura Africa

African equities have recently faced strong headwinds, despite the positive fundamental growth prospects presented by the continent, writes RisCura Africa's Business Development Executive, Gerald Gondo.

If one considers the negative return profiles of a number of the African equity indices over the last two years, it would not be surprising if investors questioned the much-vaunted tag-lines of "Africa rising" and "demographic dividend". Should they retain their confidence that Africa will master its short-term challenges and look to the long-term prospects?

An important element of the African investment case is the oft-cited demographic dividend - referring to a period where a country's workforce is young, willing and able to be integrated into the economy and thus continue its economic growth. But, other elements such as rising disposable income, urbanisation, untapped resources and agriculture also reinforce the need to look beyond short-term challenges and rather to calibrate one's expectations towards the long-term. These drivers are set to continue to develop and arguably present the prospect of compelling organic growth waiting to be unlocked.

The questions investors should be asking are who and how will Africa unlock this growth?

African governments and policy-makers appear quite clear and resolute in their outlook. Evidence of this is the 28th African Union (AU) Summit held in Addis Ababa, Ethiopia in January 2017 whose theme was, "Harnessing the Demographic Dividend through Investments in Youth".

This was perhaps a clarion call by Africa's leadership to revisit its investment case by focussing on possibly its most durable and resilient growth proponent - its youth.

Turning to the AU's "African Aspirations for 2063" - six aspirations aimed at realising the continent's potential by 2063 - Aspiration 1 reads as follows:"A prosperous Africa based on inclusive growth and sustainable development. We are determined to eradicate poverty in one generation and build shared prosperity through social and economic transformation of the continent."

Critical to making in-roads in achieving this aspiration requires African governments, policy-makers, and regulators to undertake a critical review of inhibitors to effective inclusive growth and sustainable development. Deepening, integrating and developing African capital markets is an obvious and immediate area to target.

According to a Milken Institute - Centre for Financial Markets study, "Capital Markets in the East African Community - Developing the Buyside", these markets are fundamental to economic growth because they help to channel domestic savings in a more productive way. Thereby enabling the private sector to invest, produce and create jobs. African pension funds have been cited as a growing pool of assets that can and should be channelled towards deepening capital markets.

At RisCura, we continue to observe and record the growing asset bases of African pension funds due to rising incomes, with emphasis on the need for these funds to look to diversify their investments away from traditional investments. Particular focus is given to the continued elevated levels of exposure that many African pension funds still have to government fixed income securities, which could largely be attributed to static regulation.

A separate Milken institute study in East African pension funds found that "preferential treatment generally given to government securities through regulatory approaches - specifically, relatively high portfolio ceilings - may induce funds to over allocate to this asset class at the expense of others."

If Africa is to progress towards achieving Aspiration 1, alongside the remaining six and equally important Aspirations, the pace of capital market reforms needs to be accelerated. RisCura has previously noted several major African countries have revised pension regulations in recent years, with many either considering or actually revising rules around investments such as allowing investments into private equity and non-traditional asset classes. However, the pace of revision remains slow.

Deepening of capital markets may take time, but the channelling of savings towards productive sectors of the economy is not limited only to listed capital markets. Allocations to private equity and infrastructure as alternative assets classes through the burgeoning African private equity and infrastructure funds, will serve as critical interventions to accelerating economic development in Africa.

Regulatory reform will serve as a powerful driver for increased investment that deepen and develop African capital markets. African pension funds and institutional investors have an important and critical role to play in assisting Africa (through prudent channelling of savings) with projects and initiatives that can accelerate the fulfilment of Aspiration 1.

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About the Author

Gerald Gondo serves as an Executive within RisCura Africa and is responsible for Business Development. Prior to joining RisCura, Gerald was also a founding partner of a specialist investment advisory and investment management business (Atria Africa) based in Mauritius. Gerald's passion to have first-hand experience in investing in Africa led him to join a leading pan-African asset manager (Imara Asset Management) where he had dual responsibility of being lead analyst on listed equities in Egypt, Morocco, Zambia and Mauritius whilst also building the fixed income capability of Imara Asset Management in Zimbabwe. He started his career in private equity investment in Sub-Saharan Africa (Business Partners) and has also worked as a credit analyst for a highly-rated specialist institutional fixed income boutique (Futuregrowth Asset Management), where he was responsible for credit analysis for corporate credit and securitisation issuances within South Africa.

The Supervisory Challenges of Financial Inclusion

06.06.2017Dr. Bryan Barnett, Banking Advisor US Treasury, Office of Technical Assistance

This post was originally posted on the AFI website.

In pursuit of their mission to ensure the integrity of financial systems, regulators have two distinct tasks. The first is developing the rules and regulations that govern the authorization and operations of financial institutions. The second is supervising those institutions to ensure that regulations are followed and risks are identified and addressed.

Over the last several decades, the drive to include populations formerly excluded from the formal financial system has introduced new kinds of financial products, service providers and digital technologies that have improved the lives of millions, but pose challenges for regulators on both the policy and supervision fronts. Though these developments have generated a significant amount of interest in regulatory policy, the impact of new policies on the task of actual supervision has received relatively little attention. And while there is still work to be done on the policy front, there is now an urgent need to address the practical impact of these policies on actual supervision of financial service providers (FSPs). In a rapidly changing environment, a definitive account of these impacts may not be possible, but it's not too early to consider some of the major issues and the resulting need for capacity building among financial supervisors.

Most apparent among these issues is the dramatic expansion of the number and types of financial institutions that regulators are required to supervise. Once responsible for supervising a limited number of banks, they are now increasingly expected to supervise an array of non-bank financial institutions (NBFIs), including microfinance institutions, cooperatives, SACCOs, mobile money issuers, and others. In contrast to traditional banks which are relatively few and relatively large, NBFIs are for the most part numerous and small. A supervisor formerly responsible for at most a couple of dozen institutions may now be responsible for hundreds. And whereas all banks are broadly similar, there is now much greater heterogeneity among the types of institutions and products subject to oversight.

At the same time, the increasing use of agents that may number in the tens of thousands poses special challenges. Though it is widely accepted that principals are responsible for oversight of their own agents, the task of ensuring that principals are fulfilling this requirement adequately is generally a new and different responsibility for many financial regulators. To this must be added rapid evolution in electronic payment systems, involving a host of new types of payment service providers and payment technologies. Gone are the days when it was enough to keep an eye on things like check clearing, cards or the ACH.

Since the global financial crisis of 2008-09, there is everywhere a heightened concern for consumer protection. It is a concern of special significance to financial inclusion programs that aspire to reach customers with limited literacy (financial or otherwise). Enhanced supervision under new consumer protection rules is for many regulators a largely new domain of responsibility, again multiplied by the large number of service providers concerned.

Related to all these issues is the requirement that license applications for new entrants be reviewed prior to approval and increasingly a requirement also that all new financial inclusion products be pre-approved by the regulator before being introduced. This process is exceedingly labor intensive, often requiring multiple iterations of a cycle of feedback and re-submission before a final decision is reached. Workloads are directly proportional to the pace of expansion and change in a financial services marketplace where innovation and expansion in the name of greater inclusion is often strongly encouraged. That means that workloads are expanding rapidly, threatening careful review or timely decisions or both.

These challenges are uniformly driven by policies that are here to stay and the major implications are now clear. First of all, there will never be enough staff to meet these challenges using traditional approaches. For many FSPs on-site examinations will necessarily be cursory, relatively rare or both. Moreover, with very limited human resources (relative to the scale of the task), the adoption of a risk-based approach to supervision will cease to be merely a desirable goal and will become an absolute condition of effective supervision. Given the need to develop risk profiles on numerous FSPs and products, it will be necessary to concentrate on the development of sound sector-based risk assessments and validated risk indicators that can be monitored remotely. This in turn suggests that the traditional separation of on-site and off-site supervision will need to be overcome and individual supervisors will have to be equipped to employ both approaches as and where indicated without regard for geographic proximity or any sort of programmed schedule.

Beyond sheer numbers, the heterogeneity among types of institutions and products suggests that greater specialization among available staff will be essential. This is especially acute in the case of payment systems which have significantly different mechanics and operating rules from one to the next. Moreover, the risks associated with these systems are generally not the credit or market risks associated with prudentially regulated institutions, but are primarily operational and liquidity risks that need special attention. In particular, this applies to the complex technology upon which all modern payment systems rely. There is no possibility of adequate supervision of these payment systems absent properly specialized expertise on the part of individual personnel.

Thinking about possible means to address some of these challenges, a few things are clear. First, regulators will have to rely much more heavily on information technology and develop the ability to effectively gather and analyze large amounts of remotely-collected data. This means careful attention to the structuring of data collected in monthly or quarterly reports. It means the end of reports submitted as spreadsheets that are manually consolidated and the universal use of web-based report submission backed by automated preprocessing to ensure accuracy and completeness. There will need to be a much greater use of statistical techniques to establish what is normal among a particular set of providers so that anomalies can be isolated and investigated quickly.

With respect to licensing and pre-authorization of products, it will be essential to develop simple efficient systems whereby applications can be entered electronically, workflow can be tracked, and routine communications can be automated. Where regulators are granted discretion to judge the appropriateness or adequacy of an applicant's proposed businesses or products, it will be necessary to articulate clear expectations and guidelines for the exercise of that discretion in order to alert applicants and reduce the volume of deficient applications that needlessly consume staff time.

For agents, the assignment of a unique ID for each agent and the creation of national agent registries will be necessary to provide principals with critical information about a prospective agent's prior history as an agent (if any) allowing them to avoid the cost of taking on agents with a questionable background. The same registry will facilitate consumer protection if each agent's ID number is displayed at its place of business, allowing customers to make complaints without having to otherwise collect identifying information on the agent in question.

Such a registry and ID system will also enable the development of apps allowing customers to easily rate agents or file complaints directly from their phone. That also means that supervisors will need to be prepared to process a potentially significant volume of customer complaints, some of which will be referred to a provider for resolution, others which may involve escalation of complaints that a provider has failed to address. Basic systems for tracking and analyzing these complaints will be necessary. Such systems are a common feature of many businesses, but will be very new to most regulators.

Finally, with regard to the rapidly evolving and ever more complex world of technology supporting financial inclusion, regulators will have to move away from the practice of directly inspecting provider's IT infrastructure using the regulator's own staff and will instead have to rely on a variety of qualified independent auditors and recognized international standards for certification of systems and the management of IT systems. At the same time, if not themselves conducting IT audits, supervisory staff will nevertheless need to be able to read and understand the recommendations contained in auditors' reports in order to ensure that recommendations are followed and issues are addressed.

These are surely not the only changes to traditional regulatory practice that will ultimately be required. And there can be no expectation that the changes required will be easy or quick to achieve. But it is vital that regulators begin to contemplate the future and start to plan for it. At the same time, it is critical that technical assistance and capacity building help regulators adapt traditional supervisory approaches to the new environment. The needed changes will take time and inevitably proceed in stages. But with careful prioritization and a commitment to continual progress it will soon enough be possible to look back and wonder what it was that originally seemed so daunting.

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About the Author

Dr. Bryan Barnett is an advisor for banking and financial services with the Office of Technical Assistance of the U.S. Department of the Treasury. He works with financial regulators in developing countries to help them modernize and strengthen their financial systems. A major focus of his work is helping regulators adapt regulations and processes to support expanded access to financial services to underserved populations.

Interoperability of Digital Financial Services in Tanzania

10.04.2017Kennedy Komba, Head of Strategy and Member Relations, AFI

This post was originally posted on the Alliance for Financial Inclusion (AFI) website.

In Tanzania, access to financial services for the unbanked expanded drastically when convenient and relatively cheaper options became available to receive and send money through simple feature mobile phones.

Four mobile network providers were in stiff competition in a market of 39 million registered mobile wallets (this registered wallet number does not include multiple wallet holders nor some of the dormant wallets from providers that did not exclude them after recycling their mobile numbers), 13 million of which were active ("active wallets" refers to the use of a mobile money account at least once in 90 days. This is the total number of all active accounts in the referenced month). This was in October 2014, when three of the four mobile money providers signed on to interoperability and made Tanzania the first country to successfully develop and implement standard business rules for interoperability (Source IFC: Achieving Interoperability in Mobile Financial Services: Tanzania Case Study).

By February 2016, the fourth provider had signed on and Tanzania was a global leader in the interoperability of digital financial services delivered by mobile network providers. How did this happen? This article highlights the key factors contributing to DFS interoperability in Tanzania.

Establishing an enabling environment

A regulatory environment nurturing competition and cooperation provided a foundation for dialogue and engagement around interoperability. The Bank of Tanzania, the country's central bank, played a monitoring role, ensuring that DFS providers offered services in compliance with risk mitigation frameworks (guidelines were issued that emphasized the use of international standards) that supported the dual objectives of financial stability and financial inclusion. This led to policies advocating for non-exclusivity in the use of mobile money agents and ultimately to agent interoperability. However, as the market continued to grow and mature, some market players demanded interoperability to kickstart client uptake, which had not seen rapid growth. Comprehensive interoperability was a clear need.

The Bank had to assume a leadership role in the push for sustainable interoperability. It opted for a market-based approach to interoperability, which was backed by evidence, and began to coordinate the process. It approved a neutral market facilitator, the International Finance Company (IFC) and the Financial Sector Deepening Trust (FSDT) of Tanzania, to facilitate engagement with DFS providers and reach agreement on an interoperable solution.

A market approach works

The IFC facilitated the industry-led interoperability project, with financial support from The Bill & Melinda Gates Foundation and the FSDT. This involved coordinating industry meetings to develop and reach consensus among mobile money providers on business rules and commercial agreements for interoperability and submit them to the Bank of Tanzania for consideration. This exercise began in September 2013 and, after several meetings in which participants reached a greater understanding of the regulatory framework, market demand, payment systems and rule development, consensus was reached. A year later, in September 2014, two of the four mobile network operators (MNOs) signed off on the wallet-to-wallet operating rules, which led to technical arrangements to initiate interoperability. In December 2014, the third MNO came on board. It took another year for the fourth to sign on, and by February 2016, Tanzania was one of the first markets in the world to have full interoperability of mobile money services (Figure 1).

Figure 1: Key Milestones for Mobile Money Interoperability in Tanzania

Other markets could learn lessons from Tanzania's journey. It is worth noting that although Tanzania was well-suited to a market-based approach to interoperability, with its supportive central bank, conducive regulatory framework, and a sufficient level of market competition and maturity, two other factors played an important role: (i) the value proposition for the private sector was taken into account; and (ii) private and public sector dialogue was enhanced through the public policy lens of financial stability and financial inclusion. This helped the regulator balance its dual mandate and ensure financial inclusion initiatives do not compromise financial stability.

The next frontier

Tanzania's interoperability journey is still underway: the market is currently expanding the use case for interoperable services through merchant payments and extending interoperable services beyond MNOs to banks and other players. This will also involve improving the clearing and settlement process, shifting from bilateral arrangements to a multilateral process that includes a switching process. The Bank of Tanzania is continuing to play a monitoring role and provides guidance and direction on a process that is efficient and creates value not only for market players, but also for users and other stakeholders. In the end, this will ensure the best solutions are implemented and satisfy both private sector and public policy objectives-a task guided by the same principles that led to interoperability in the first place.

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About the Author

Kennedy Komba is currently Head of Strategy and Member Relations of Alliance for Financial Inclusion. Prior to this new role which he assumed in April 2016, he was the Senior Advisor of the National Payment System in the Bank of Tanzania. He is an Accredited Fellow of Macro-economic and Financial Management Institute of Eastern and Southern Africa (MEFMI) and a Fellow of Fletcher Leadership School for Financial Inclusion of Turf University, USA. He has experiences in financial inclusion policy, strategies and regulatory frameworks. He was instrumental in leading the development of the Tanzania regulatory framework for the National Payment Systems including electronic money regulations. He also was involved in the development of the Tanzania National Financial Inclusion Framework.

Anti-Money Laundering and Counter Financing of Terrorism (AML/CFT) in Nigeria - A Call for Rescue

13.03.2017Dr. Abdullahi Y. Shehu

This post was originally posted on This Day Live.

The aim of any AML/CFT regime is to prevent, detect, interdict and control money laundering and the financing of terrorism. The global framework for this is adumbrated and elaborated in the Financial Action Task Force (FATF) 40 Recommendations on Money Laundering, and the Financing Terrorism and Proliferation (2012). In brief, the Recommendations set out measures, including AML/CFT policies and coordination; criminalization; prevention; transparency; as well as powers of competent authorities and international cooperation, for the prevention and control of these phenomena. The forty recommendations, the acceptable international standards against money laundering, terrorist and proliferation financing and are enforced globally. The enforcement of these measures is monitored through the FATF network process of peer review known as 'mutual evaluation'. Countries that are not members of the FATF or its Regional Style Body are targeted based on perceived deficiencies and risks from their jurisdictions and engaged by the FATF for the purpose of enforcing compliance with the standards.

The FATF Standards, even though referred to as recommendations have become powerful tools for combating transnational organized crime and their enforcement has become a major policy issue in all jurisdictions. Indeed, the spirit and letter of the standards have proven over the years to promote sanity and best practices and protect the international financial system. Thus, any country enforcing the standards does so in its own interests and not necessarily satisfying foreign obligations.

The Nigerian AML/CFT Regime

Although Nigeria is not a member of the FATF, it is a founding and active member of the ECOWAS Inter-Governmental Action Group against Money Laundering (GIABA), which is a FATF Style Regional Body responsible for the promotion and enforcement of the FATF standards in West Africa. Accordingly, Nigeria has committed to the full implementation of the international standards against money laundering, terrorist and proliferation financing. Nigeria's AML/CFT was the first to evolve in the west Africa, and indeed the whole Africa, because the Nigerian Money Laundering Decree No. 3 of 1995, even though it criminalized only drug money laundering, was the first piece of legislation against money laundering in Africa. Nigeria was the first country in West Africa to establish a specialized agency (the EFCC) for money laundering enforcement; the first to establish a Financial Intelligence Unit (FIU); and most importantly, it was Nigeria's leadership, in collaboration with the UNODC and the ECOWAS that led to the establishment of the regional body (GIABA). Unfortunately, however, and despite being the first to put in place the initial structures for AML, Nigeria missed the opportunity to become the first African country to attain a FATF membership, mainly because Nigeria's efforts were not properly coordinated and sustained.

By the FATF fundamental and technical criteria, Nigeria is no doubt a strategic country obviously because of the prevalence of corruption and money laundering, but mainly because of its GDP, the size of its banking and financial system, its integration with the international financial system, as well as its geographical and political influence in Africa. As a result of none response (in fact nonchalant attitude) of Nigeria to engage, the FATF was left with no alternative than to blacklist Nigeria among countries considered to be non-cooperative countries and territories (NCCTs) in 2001. Subjecting Nigeria to this process meant that Nigeria was perceived as a risky jurisdiction for business and all financial transactions with Nigerian banks were subjected to extra ordinary scrutiny - and embarrassment. But this did not stop the laundering of proceeds of corrupt enrichment from Nigeria in other jurisdictions anyway. I am not going into the details of the responsibilities of other jurisdictions here as it is not the aim of this article.

It took Nigeria six years of engagement to be removed from the NCCTs process in June 2006. One of the conditions for Nigeria's removal from the black list was for Nigeria's AML/CFT system to be evaluated by GIABA to ascertain its level of compliance with acceptable international standards. The first comprehensive mutual evaluation of the AML/CFT regime was carried out in 2008 and the report showed significant deficiencies, particularly in strategic areas like insufficient criminalization of the offences of money laundering and terrorist financing, lack of effective regulation and supervision of the financial system, inadequate records keeping of financial transactions, insufficient measures for the enforcement of United Nations Resolutions 1267 and 1373 with respect to financing of terrorism, and lack of mutual legal assistance law to facilitate effective international cooperation, among others.

These deficiencies again, made Nigeria to be subjected to the FATF review under its International Cooperation Review Group (ICRG) process in 2010. By subjecting Nigeria to the two FATF processes of global enforcement is not suggestive of Nigeria's strategic importance; but rather notoriety for non compliance, which is not good for the image and integrity of the country. Nigeria suffered the consequences and also had to invest both in human and material resources to get out of this process in 2013. As an active participant in all these processes, I feel very bad for my country and all this is blamed on lack of synergy and coordination of Nigeria's efforts. There are too many stakeholders in the AML/CFT arena, and yet leadership remains a huge challenge.

Within the framework of the GIABA processes, the ministers of Finance, Justice and interior in each country are responsible for AML/CFT, but the obvious responsibility going by the FATF standards lies with the minister of finance. I was told the Minister of Justice has this responsibility in Nigeria, and yet sixty percent of AML/CFT obligations lay within the financial sector. Furthermore, the key strategic technical deficiencies, notably, the lack of a mutual legal assistance, asset recovery and management laws, as well as harmonization of the money laundering and terrorism prevention laws are the responsibilities of the minister of Justice.

Vulnerabilities and Risks in the AML/CFT Regime

The main thrust of AML/CFT is the identification and mitigation of risks. That is why the international standards place emphasis on risk assessment, which Nigeria has recently done but the report is yet to be released. Without pre-empting the outcome of the risk assessment, I know for certain that since 2013 after Nigeria was removed from the FATF ICRG Process, the following fundamental weaknesses remain in its AML/CFT regime:

  • Absence of compressive mutual legal assistance legislation;
  • Lack of Proceeds of Crime Law;
  • Lack of harmonization of the various amendments made to the Money Laundering (Prohibition) and the Prevention of Terrorism Acts 2013 to make them consistent with acceptable international standards;
  • Ineffective coordination of the overall AML/CFT regime;
  • Controversy surrounding the status and location of the Nigeria Financial intelligence Unit (NFIU);
  • Lack of credible records of statistics on the achievements in AML/CFT;
  • Obvious or visible patterns of money laundering through various methods, including massive outflow of cash, real estate and the prevalence of corruption;
  • Poor records of dealing with 'high profile' corruption cases, most of which remain inclusive; and
  • Weak beneficial ownership and legal arrangements, among others.

It should be noted that these weaknesses are within the technical compliance requirements; meaning that there is more to be done to achieve effectiveness as a pre-requisite for the next round of evaluation under the revised FATF Standards.

Rather than for Nigeria to focus on addressing the strategic deficiencies in its AML/CFT, which would automatically give it credit and recognition to become a member of the FATF if that is Nigeria's ultimate objective; there is a misplaced priority on Nigerian officials' participation in FATF Plenary meetings to "observe and learn" nothing that is not already known on AML/CFT. How can that change the system back home other than draining resources? It is disappointing, to say the least, that many countries, most of which are less endowed than started the process after Nigeria, but due to their commitment and prioritization of actions, they have surpassed Nigeria in many aspects. This is why my own contribution is not a critique per se, but a call for rescue to address the weaknesses in the Nigerian system.

Nigeria's Membership of the FATF

Becoming a member of the FATF is desirable for Nigeria, but it is not a priority. What is a priority and important for Nigeria is to review its AML/CFT architecture and address the specific technical deficiencies that would provide the building blocks for a solid regime. Without those building blocks being in place, little can be achieved in terms of effectiveness, talk more of aspiring to become a member of the FATF. In any case, Nigeria can play a leading role within the regional AML/CFT framework that can earn it the respect of the international community and by so doing, becoming a member of the FATF will be much easier. In fact, the FATF will be the one courting Nigeria rather than Nigeria struggling to become a part of it.

At any rate the criteria for attaining FATF membership are clear and these include the technical requirements that a country must achieve nothing below the rating of largely compliant on the core recommendation 3, which has do with criminalization of money laundering; recommendation 5, which has do with criminalization of terrorist financing; recommendation 10, which deals with customer due diligence; recommendation 11, on records keeping; and recommendation 20, on reporting of suspicious transactions. Can the current status of the NFIU achieve this requirement?

The Status and Location of the NFIU

Practitioners in the AML/CFT cycle have always asked and would be eager to know my view with respect to the seemingly controversial status and location of the NFIU. I have come to realize that the problem with the NFIU is not with its operational independence as most people would claim, but with a misplaced notion of who is in charge of what and a misperception of public office as a personal and life time vocation. Perhaps the most credible arguments in the controversy for a review of status and location of the NFIU are that: (1) the EFCC being a law enforcement agency cannot at the same time be the FIU of Nigeria as contained in section 1 (2) of the EFCC Establishment Act; and (2) the NFIU has not been administered professionally to make it truly a centralized authority for all law enforcement agencies to derive financial intelligence from it, rather, it is perceived as the property of the EFCC. Indeed, we must acknowledge the foresight and good leadership of the EFCC in establishing and strengthening the NFIU, but since we must conform to acceptable standards, what is required is either to enact a standalone law establishing the FIU according to the Egmont standard, or amend the EFCC Act to say the FIU is located within the EFCC as it has to be located somewhere anyway.

There is no proof that the FIU can be better in any other location other than where it is at the moment. After, all what is in a location? It is instructive to note that what is required is the operational autonomy and financial independence of the FIU and its ability to serve all law enforcement agencies. That can be achieved through either of the two alternatives contemplated here. This seems to be a hard nut to crack, but it must be done somehow if the system must work very well.

Conclusion and the Way Forward

Anti-money laundering and counter financing of terrorism is an important element of the fight against corruption, which is one of the main thrusts of the government of Nigeria. Yet, since 2013, no significant input has been added to the AML/CFT framework. As Nigeria seeks to strengthen democracy by reinforcing rule of law, there is no alternative to strengthening the mechanisms for accountability, including a robust ML/CFT regime. These issues are neither academic, nor are they political, inspite of the legislative processes; they are purely technical issues, which require technical expertise to address. With South Africa as a member of the FATF and with Egypt nearer to attaining membership, the regional balance that FATF sought for may have been achieved to some extent. However, it would still be a fact that sub-saharan African is not represented and it would be a disappointment if any other country will overtake Nigeria and become a member of the FATF. The second round of the evaluations have already commenced and if the Nigerian system remains as it is with the strategic deficiencies mentioned earlier on, Nigeria's leadership and influence in AML/CFT will diminish regrettably. Time is of the essence and a word is enough for the wise.

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About the Author

Abdullahi Shehu is a Professor of Criminology and former Director General of the ECOWAS Inter-Governmental Action Group against Money Laundering (GIABA).

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