Business Cycles, Financial crisis, and financial ...

Management of Financial Crises: Priorities for Rebuilding the Financial Architecture in Africa John K. Karuitha Department of Accounting, Finance & Management Science Egerton University [email protected] Samuel O. Onyuma Department of Economics & Business Studies Laikipia University College [email protected]

Abstract After the global financial crisis, questions have been raised regarding the suitability of the current risk management models and the regulatory framework. Even before the financial crisis (2007 – 2009) and the ensuing debate dies down, the sovereign debt crisis (2010-2012) in Europe has again highlighted just how vulnerable the financial sector, including the core of the payment system, is to external shocks. With the lenders to Greece being forced to take a “hair cut” on their existing debt holdings, and the unforeseen political crisis resulting from the Arab Spring in Tunisia, Egypt, Libya, and Syria, there is need for a relook on the way risk is assessed, management of government debts and the transition to common currencies in African economic blocs. Using a multi-country analysis of literature internationally accepted, this paper analyses the causes of the global financial crisis, sovereign debt problems in Europe and espouses on the important lessons that African economic trading blocs can learn in their pursuit towards creation of single currency areas, private and sovereign debt management, tools for financial risk and investment management, and the need for robust and innovative financial system regulation. With various African economic blocs considering creation of monetary unions, the paper highlights some pitfalls that should be avoided and how the regions should go about introducing the common currency. The paper recommends a relook at the risk-free concept, and suggests that with assets in a portfolio, including government debt, being inherently risky, portfolio risk measurement models should be reviewed. It also recommends for greater and more effective coordinated financial sector regulation. Finally, the paper concludes on the inevitability of business cycles and recommends a model to predict their occurrence.

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1. INTRODUCTION The global financial crisis set a record of sorts. There was, among others, the run on British Bank Northern Rock in USA. And then there was the crisis at the Royal Bank of Scotland- blamed on poor management and weak regulation, and most of all the collapse of Lehman Brothers. The sovereign debt crisis in Europe is weighing heavily on banks and countries like Greece, Italy and Spain. Subsequently, the focus is on the financial system regulation, bank capitalization, risk and liquidity management, and efficiency of Banks. There has been the emergence of new regulations for the financial system- the Basel III, Solvency II in Europe and The Volcker Rule in America stemming from the global financial crisis. In the EU, a monetary union without a corresponding fiscal union is being called into question. The state of financial markets and the payment system have major implications to the economic stability of Nations. The banking debacle in Japan in the early 1990s resulted in a $725billion in nonperforming loans by 1998. The massive asset crash that followed (from 1998) marked the beginning of the lost decade for Japan. The new IMF boss Christine Lagarde has pointed to the possibility that 2007 may have marked the start of a lost decade for Europe and USA (Bloomberg, 2011). It is generally accepted that business cycles and financial crises are inevitable. Thus, trying to stop business cycles from occurring would be a waste of time. What is required is a set of interventions that could help mitigate their effects and/or predict their happening. The starting point is to identify the commonalities of the cycles. Surprisingly, there is no commonly accepted definition of global recession. In this article we view it as a contraction in world real per capita GDP accompanied by a broad decline in various other measures of global economic activity. There have been four global recessions in post-World War II period: 1975, 1982, 1991, and 2009. A look at the Laeven and Valencia (2012) database

including all systemic banking, currency, and sovereign debt crises during the period 1970– 2011, reveals some striking similarities and differences in policy responses between advanced and emerging economies. However, the tools used to deal with the crises seem to a larger extent alike. Kose et al. (2009) have maintained that the 2009 global recession was the deepest and the most synchronized of the post war period. It is a stylized fact that asset market booms precede the busts and global recessions. So why did these spirals in the financial markets reoccur in 2007 causing the 2009 recession? To begin with, there was a blind trust in the power of the market to efficiently allocate financial resources leading to a huge deregulation of the financial sector in the last two decades. Second, poor risk management practices based on over simplistic models and that did not keep up with financial innovation did not help matters. Furthermore, the inadequacy in governance arrangements and weak regulation of the financial system made it almost impossible to stem the crisis. All this was exacerbated by rating agencies beset by conflicts of interests, complex structured products with 2

embedded options sold to investors, and the huge counterparty exposures that created severe risks of counterparty failure (Turner, 2010). The global crisis that started in 2007 put everything into reverse gear, and now the former advocates of deregulation – The British and The Americans – are in agreement with the rest of the world on one thing; the need to relook at the regulation of the financial system. It seems that like markets, regulation too has suffered from booms and busts in the past three decades, with each era of deregulation followed by an era of a degree of financial oppression. The reason may be that even the regulatory agencies are comprised of individuals that are part of the financial system and subject to the irrational exuberance that afflicts all other economic actors. With the lenders to Greece being forced to take a hair cut on their existing debt holdings, and the unforeseen political crisis resulting from the Arab Spring witnessed in Tunisia, Egypt, Libya, and Syria, there is need for a relook on the way financial risk is assessed, private and government debts managed, and how to manage the transition to common currencies in African economic blocs. Using a multi-country analysis of literature universally accepted, this paper discusses the current issue of global financial crises and the lessons which Africa can learn from the unfolding financial problems in relation to use of financial risk management, creation of monetary unions, and the management of government debts. This paper is structured as follows: the next section explains the causes of the global financial crisis and the European sovereign debt problems. It then discusses the important lessons that African economic trading blocs can learn the use of financial risk and investment management strategies, and sovereign debt management and the creation of common currency areas. With African economic blocs, including the East Africa Community, considering creation of monetary unions, the paper highlights some pitfalls that should be avoided and how the regions should go about introducing the common currency. The paper recommends a relook at the risk-free concept, and suggests that with assets in a portfolio, including government debt, being inherently risky, portfolio risk measurement models should be reviewed and not used blindly. All these call for the need for a robust and innovative financial system regulations. Finally, the paper concludes on the inevitability of business cycles and recommends on how to predict their occurrence.

2. GLOBAL FINANCIAL AND SOVEREIGN DEBT CRISES The Global Financial Crisis The genesis of the crisis of 2007 can be traced to a number of factors: the collapse of Soviet Union in 1989 that gave rise to the peace dividend, where funds previously directed to containing the Soviet Union by the USA and Europe, were suddenly released into the global capital market; and the reaction of countries after the Asian currency crisis of 1998. Having faced a severe currency crisis, Asian countries adopted a more stable export oriented growth model, immediately converting their reserves into dollars (Singh, 2010). With time, the USA started building up a current account deficit, while 3

countries in Asia (including India and China) and oil exporting countries were building up surpluses. It is these surpluses that were being used to fund the deficit in the USA current account. This global imbalance was exacerbated by emergence of sovereign wealth funds, state - owned investment vehicles which invest their surpluses in global financial assets. Globalization caused by collapse of Bretton woods system and oil shocks in 1973-74 (Boughton, 2009), and the broadening of the investment guidelines of pension funds. In fact, the pension funds were allowed to invest in smaller mid – capital companies, which was the spark for the growth of venture capitalism. Later, there was abundance of funds in the market that fuelled an asset boom before 2007 (Berglof, et al, 2009). The fact that financial assets have an upward sloping demand curve – the higher the prices, the higher the demand – further fuelled the bubble. When investors have bought too much of the assets, prices will inevitably fall as demand and supply become out of synch. During the years preceding the credit market collapse, the sub-prime mortgage industry thrived (Shiller, 2007). The global financial crisis, which began in mid 2007, was caused by the collapse of the sub-prime mortgage market in USA. A sub-prime borrower refers to borrowers whose credit ratings fall below a certain rating level, 620 points in USA (Dell’Ariccia, 2009). These were mostly unemployed, parttime, or lowly paid temporary workers. Lending to these groups led to very high risk debtors in the mortgage market. The sub-prime debts were re-packaged and sold to banks and other financial institutions in USA, Europe and Asia. Individuals with poor credit rating were given access to loans they really could not afford. But as long as home prices were on the rise, these poor lending practices were simply ignored. That is because lenders could afford to write off these bad loans as long as the homeowner's equity in their house outpaced their desire for new debt. If borrowers were to fail to pay back their loans, lenders could always foreclose on the home – an asset with ever-increasing value. There was also aggressive securitization of high risk financial assets. The belief that housing prices would never fall fuelled the subprime boom- with too many households, even the ones that would ordinarily not afford a home (subprime) owned houses due to this abundance of cash at low interest rates. As bubbles build, market optimism increases leading to an upward sloping demand curve, but at a decreasing rate. At the peak of an asset bubble, a minor prickle is enough to trigger a massive crisis. The crisis was triggered by defaults in the subprime mortgages in USA market, where subprime lenders charged higher risk premiums on the subprime loans that Together, these factors led to shortage of liquidity – credit crunch; global economic down turn – with economic growth rate dropping to 0.5% in 2009 compared to 3.5% in 2008 (Sisk, 2009); economic crisis – bankruptcies, rising unemployment and foreclosures; and confidence crisis with investors and consumers losing confidence in financial markets. Equity return performance in the banking sector reduced in both developed and emerging markets (Chan-Lau et al., 2012) and there

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was a sharp decline in tax revenue following the great recession of 2007–08 on state and local governments in the USA (Jonas 2012). Although the financial crisis did not immediately impact on African economies, the effect was later severe as it had direct hit on sources of financial inflows. For instance, remittances from Africans leaving in the Diaspora dropped, in addition to decline in foreign aid, private capital flows, and demand for African exports. The crisis also led to rapid depreciation of certain African currencies, sharp decreases in stock market prices (Onyuma, 2012a) and negatively impacted in investments in fledgling African securities markets (Blanchard, 2009). African countries faced reduced export demand and reduced access to trade credit. And many in Eastern and Western regions are already suffering from the other crisis – the food and fuel crisis that has strained national budgets and balances of payments, and raised inflation and living costs. The Sovereign Debt Crisis The European sovereign debt crisis is an ongoing financial crisis since 2009 that has made it difficult or impossible for governments to refinance their debt without the assistance of third parties (usually other Governments, and the IMF). Due to rising debt levels among governments around the world. This was made worse by the downgrading of some European governments (Spain, Italy, and France) debt by the major rating agencies. The European debt crisis has been blamed on globalization leading to easy credit conditions, international trade imbalances, real estate bubbles, fiscal policy choices by governments, and approaches used to bail out troubled banks during the global financial crisis by socializing losses, and the economic slowdown that followed. Therefore, globalization has two faces; it has benefits, as well as costs (Kose et al, 2007). Large fiscal financing needs, both in advanced and emerging market economies have often been met by borrowing heavily from domestic banks. As public debt approached sustainability limits in a number of countries, however, high bank exposure to sovereign risk created a fragile interdependence between fiscal and bank solvency. Adler (2012) has presented a simple model of twin (sovereign and banking) crisis and stressed how this interdependence creates conditions conducive to a self-fulfilling crisis. Interestingly, the causes and reactions to both the 1980s savings and loans crisis and the 2008 financial crisis seem to be similar (Docking, 2012). Like the global financial crisis, high growth emerging economies awash with cash were looking for higher yield investments. This easy money led to debt build up among European governments. Thanks to complex currency and credit derivatives, European countries were able to take up debt in excess of that agreed upon in the Maastricht Treaty1. Ireland banks lent the money to property developers leading to a massive asset boom. In Greece, the government increased salaries and gave generous pensions. In Iceland, banks held external debts 1

The treaty on the European Union was signed on February 7, 1992. It created the EU, led to the creation of single European currency - Euro, and fixed government deficit at no more than 3% of GDP of the preceding fiscal year.

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larger than the country’s GDP. The interconnectedness of the global financial system means that problems in one country spill over to other countries, a phenomenon known as financial contagion. Greece has been hit the hardest by the crisis, though Portugal, Ireland, and Cyprus have also been affected. There have been talks that Greece should withdraw from the Euro and reintroduce the Drachma, a move that critics could be devastating for the country. Due to globalization, the crisis has spread from Greece to other countries in Europe, most notably Italy, Spain, Belgium, and France. Countries whose banks held significant proportions of Greek debt have been especially affected. As condition for receiving bail out from the IMF, Greece was forced to undertake severe austerity measures – that further risk to slow the economy – and negotiate with creditors a hair cut where the value of government debt held by the creditors would be reduced, and the maturity of the credit extended. The European Central Bank has since availed massive cheap loans to the banking sector in a bid to enable them repay their debts and also to continue lending so as not to choke economic growth. In addition, Europe has also created the European Financial Stability Facility (EFSF), a legal instrument aimed at preserving financial stability in Europe by providing assistance to Euro zone states in difficulty. The EFSF can issue bonds or other debt instruments on the market with the support of the German Debt Management Office to raise the funds needed to provide loans to euro zone countries in financial problems recapitalize banks or buy sovereign debt. The bonds are backed by guarantees given by the euro area member states in proportion to their share in the paid-up capital of the European Central Bank. An important dimension of the Sovereign debt crisis is the monetary policy inflexibility experienced by countries in the Euro-zone. Membership of the euro zone means that a member state can no longer independently print money in order to pay debts and ease their default risk. This monetary policy union, without a corresponding fiscal policy union has left affected countries such as Greece in a precarious situation. 3. IMPORTANT LESSONS FOR AFRICA FROM THE FINANCIAL CRISES Africa is currently being viewed as the next investment destination due to its vast untapped natural and trained human resources and growing population and rising middle income class. Many global commercial banks, fund managers and other financial institutions are spreading their branch networks into Africa. The AU is already planning a single currency for Africa. Different economic and trading blocs are being created with common market protocols and objective of financial markets integration. Already there are plans of creating a Pan African Securities Exchange. Many African governments are turning to Asia for borrowing, with China offering cheap debt with better loan conditions. Given these developments Africa needs to move cautiously, while taking into considerations the financial problems being witnessed in USA and the Euro area. The following lessons can be drawn by Africa from the recent global financial crisis and the current sovereign debt crisis in Europe.

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3.1 Sovereign Debt, Financial Risk and Investment Management Government Debt and the Risk Free Rate Historically, government bonds appeal to investors by the virtue that they are risk free. The risk free assumption that is used as a benchmark for asset pricing is based on the fact that governments hardly default. Two recent developments have radically altered this assumption. First, is the debt crisis in Europe, and especially in Greece where the government would have defaulted were it not for the support from the EU and the IMF. The second is the deadlock in the USA on whether or not to raise the debt ceiling. The Economist (2012) has captured this well by noting that fifteen years ago Western government bonds were regarded as being like porridge: stodgy but easily digestible. Investors knew returns would be modest but perceived the asset class as risk-free, an important concept in both financial theory and portfolio construction. However, things are however different now. The bond vigilantes were asleep at the wheel as debts mounted in the euro zone, waking up in time to provoke the latest crisis but not avoid it. Privatesector bond investors in Greek sovereign debt face losses of around 70 percent, making the idea that government bonds are risk-free laughable. The fat tailed distribution of risk in government securities need to be recognised- that the probability of sovereign default is low, but when it does happen, the potential losses are massive compared to the high probability risk scenarios. What this means is that government debt is not risk free but merely the least risky asset in the investor’s portfolio. The problem is how to quantify this risk, given that financial crisis do not occur often enough to allow for empirical analysis and estimation of risk. Again, different countries will have different risks, even when their debt holdings are equally high. This article suggests that the ratio of debt to GDP, interest rates in international markets, and economic conditions (boom or recession) could be a good indicator of riskiness of sovereign debt. This risk is a variable that can be explained by the actions of economic actors given the prevailing economic environment. Thus, the risk of default is a function of economic conditions, interest rates, and the ratio of government debt to GDP. This risk could then be inferred from the historical lessons, in the absence of other appropriate measures. Given a measure of risk to be used as a base determining asset prices, provisions to cover this sovereign risk should be made that is proportionate to the amount of government debt in the portfolio. In addition, the extent of exposure debt on the home countries of the counterparties to the sovereign debt should be monitored regularly. The debt crisis in Europe originated from Greece and is threatening not only the common currency but also countries in the Euro area that had no problems servicing their debt, for example France. A Sovereign debt is assigned a zero weight when computing the minimum risk weighted capital of the Basel Accords. This means that institutions holding such debt have no cushion whatsoever, but bail outs from multilateral donors and the Government, in the case of default. The risk weight on sovereign debt should not be given an automatic zero weight. The risk weight should be adjusted depending on, for example, the debt to GDP ratio of a country.

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Performance and Compensation of Investment Managers One of the major weapons in the armoury of the board of directors to align the objectives of managers and those of shareholders is executive compensation. However there are problems in both contract writing and enforcement and in specifying the appropriate performance measures and the time horizon for the award of compensation (Ruud, 2008). Current management compensation models raise ethical concerns by the sheer size of the bonuses paid by banks that not too long ago were rescued by the tax payer, and the perception that they encourage short-termism (Johnson, 2010). Scholars such as Bebchuk (2004); Gabaix and Landier (2008) and Thanassoulis (2012) have argued that entrenched top managers capture the pay setting process and manipulate the boards into awarding them excessive pay. In fact, these executive compensation methods like executive options have been blamed for poor corporate performance (Onyuma, 2011) since top management use them to hide many of the staff costs. Whereas shareholders desire steady return on investment, short termism may lead to excessive risk taking by corporations which later has to be borne by tax payers in the form of bail outs. The compensation models need to be reviewed. They have been suggestions that compensation models should include a claw back mechanism- where managers should be made to repay back the bonuses if the firm’s prospects fall within a predefined window period, say ten years after their exit. So, how should financial institution managers be compensated in Africa? There is a need for a relook at the ways managers are compensated so that they do not take up excessive risk in a bid to maximize their compensation. One suggestion is to have manager’s bonuses be paid in stock and the stocks so issued have a long term exit clause (say 10 years) with an embedded option to revert back to the corporation if the subsequent performance of the company is poor. This will encourage managers to look into the long term while making investment decisions. We also suggest that regulators should place a weak cap on executive compensation to be based on a percentage of balance sheets that can be used to finance CEO’s pay and bonuses (as in Thanassoulis (2012). The arguments against capping executive pay are that there is likely to be a shortage of talent. We argue that the shortage may not outweigh the risk taking that such excessive compensation induces. After all, CEOs attract among the highest pay, and a global cap on compensation leaves them with no substitutes. Avoiding the Herding Mentality in a Bull Market Behavioural finance theorists have long argued that markets are driven by overconfidence and greed (causing bubbles) and pessimism and fear (that bursts the bubbles). Laws of insider trading are based on the assumption that managers are always in the know, and so capable of making superior investment decisions than ordinary investors – despite the lack of conclusive evidence in support. A key question then is why investors tend to exhibit herding mentality, the tendency to pile into a narrow range of asset classes instead of truly embracing diversification? For example investors (including the more informed ones), buy more and more stock when the stock market is performing well, making for an upward sloping demand curve in financial markets. And bankers did excessively 8

lend out to subprime borrowers to purchase such assets, thus further fuelling the price increase. In fact, herding makes diversification by investors irrelevant by reducing the extent of correlation between the target assets. Past crises have shown that economic stability and booming credit (the fuel that feeds financial market bubbles) are seeds for the next big economic and financial crisis. The problem is that this low - volatility environment gives a false sense of safety as it is based upon historical records, and investors have the tendency to make future projections on the back of this. This gives investors a false justification to add more leverage to their positions, which further fuels the bubble. Investors to Africa are not immune to herding. From the EMH, we know that markets have no memory- which is indeed true for investors. Investment managers should develop a memory and must bear in mind that even when the economy is booming, credit markets roaring and the market is bullish, it would be dangerous to herd along with the crowd- but rather prepare for a correction. Investment managers must keep track of the credit markets because the drying up of the credit markets marks the onset of the bursting of bubbles. The manager could liquidate some of his holding and get ready to buy later when the market hits rock bottom. In fact, in anticipation of a market crash, investment managers are advised to narrow their diversifications because diversification only serves to increase risk in a portfolio in such times. These managers can as well us liquidity in the market to predict emerging market crashes. Modern Portfolio Theory and the Bear Market Investment finance rotates around the modern portfolio theory (MPT) and the fact that the market cannot reward an investor for taking up unsystematic risk that can be diversified away. The crisis however has proved that the MPT does not apply in all conditions. Since its inception by Markowitz (1952), the MPT had not been stretched to the limits that the global financial crisis did. And the implications were astounding. During the crisis, adding portable alphas to portfolios and even diversification across several different asset classes didn’t work, since every major asset class appeared to be under attack. On paper, diversification principles carry elegance and neatness but where modern portfolio theory suffers the greatest weakness is in its assumption that in every market, correlation is below 1.00. What was observed during the crisis years, whether it is managed on the basis of fundamental factors, momentum, arbitrage, or any other rationale, is that everything tends to end up on the same side of the trade at the same time. Believers in portfolio theory are convinced that (for instance) alternative investments are somehow negatively correlated with basic equities. During 2007 – 2009 they learned the hard way that this was simply not true. Bonds, equities, commodities, and currencies are not asset classes in their own right (Choudhry and Landuyt, 2010). In fact of all asset classes only dedicated shorts and managed futures realised a positive returns as per the Credit Suisse/Tremont Hedge Funds Index over the peak crisis period.

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Even for financial institutions that branched out and started operating globally in a bid to diversify away risk, the lesson was that the strategy, during times of crisis actually serves to magnify risks, not reduce them. In fact, diversification only works in a bull market, not a bear market. Thus diversification cannot be used as a substitute to sound liquidity management or a firm capital base for financial institutions. Investment managers and bankers in Africa should bear in mind the fact that diversification, while good, has limits. Some East African banks and other businesses have been expanding rapidly in the region, with the opening of branches in the region. For example, Equity Bank and KCB have branches in Rwanda and Southern Sudan. Nakumatt Supermarkets has recently expanded into Rwanda. Banks and other businesses from other regions of Africa and beyond have also expanded into Kenya. A Pan African bank, Ecobank has acquired EABS Bank in Kenya. While not fighting diversification, managers ought to make provisions for bad times when systemic crisis makes diversification counterproductive, or at best of no value added. Diversification should be based on a genuine understanding of the risks underlying an asset or geographical region into which the investment managers or banks wish to diversify into. For banks, it would be imprudent to over leverage on the capital base. It is also suggested that they secure long term liquidity to allow for times of long time market corrections and illiquidity. For most of the banks, insurance companies and hedge funds that ran into trouble, the problems were, among others, extreme leveraging on the capital base. Usefulness of Corporate Rating Agencies Rating agencies are seen as beset with conflicts of interest. They have been accused by being paid by the firms being rated and applying over-simplistic ratings models. That rating agencies are in business, and their managers may have strong connections with the firms being rated raises the probability of conflicts of interests. Of late, many rating agencies have mushroomed in Africa with Dun & Bradstreet, Global Credit Rating, Metropol Corporation, etc actively engaged in this business. The implication for Africa is that the rating agencies may not be in real position to determine the creditworthiness of a financial institution, leave alone that of a country. To reduce the conflict of interest faced by rating agencies, an obvious solution would be that they should be paid by the clients, and not by the entities being rated. This is likely to place undue burden on the investor. This paper suggests that rating agencies should be paid by the regulators through a pool of cash contributed by firms being rated and a small transaction tax on capital and money market transactions. In addition, regulators at the global level should explore the feasibility of having a credit rating framework that unifies how credit rating is done. This may also include having set standards for credit rating that specify the minimum acceptable quality in credit rating. This would mean that only the best and proven credit rating models are applied, and when found to be inadequate, they are reviewed at a global level.

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Cautious Use of Financial Innovation and Risk Management Strategies Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities. This strategy began in the 1970s, when home mortgages were pooled by U.S. government-backed agencies. In the 1980s, other income-producing assets began to be securitized, and in recent years the market has grown dramatically. In some markets, such as those for securities backed by risky subprime mortgages in the United States, the unexpected deterioration in the quality of some of the underlying assets undermined investor confidence. Both the scale and persistence of the attendant credit crisis seem to suggest that securitization – together with poor credit origination, inadequate valuation methods, and insufficient regulatory oversight – could severely hurt financial stability. Financial institutions are increasingly employ securitization to transfer the credit risk of the assets they originate from their balance sheets to those of other financial institutions, such as banks, insurance companies, and hedge funds. They do this because it is often cheaper to raise money through securitization, and securitized assets were then less costly for banks to hold because financial regulators had different standards for them than for the assets that underpinned them. In principle, this originate and distribute model brought broad economic benefits too – spreading out credit exposures, thereby diffusing risk concentrations and reducing systemic vulnerabilities. But what should be the risk weight for securitized products that are mostly off-balance sheet? We suggest that the risk weight for secondary products should be based on the underlying asset, or the riskiest of the underlying assets – if more than one – and the risk rating of the counterparty. The process of securitization passes through two steps. First, a company with loans or other income-producing assets – the originator – identifies the assets it wants to remove from its balance sheet and pools them into what is called the reference portfolio. It then sells this asset pool to an issuer, such as a special purpose vehicle (SPV) – an entity set up, usually by a financial institution, specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes. Secondly, the issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio. In most cases, the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on – less a servicing fee – directly to the SPV or the trustee. Thus, securitization represents an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risk) from issuers to investors. In a more recent refinement, the reference portfolio is divided into several slices, called tranches, each of which has a different level of risk associated with it and is sold separately. Both investment return (principal and interest repayment) and losses are allocated among the various tranches according to their seniority. The least risky tranche, for example, has first call on the income 11

generated by the underlying assets, while the riskiest has last claim on that income. The conventional securitization structure assumes a three-tier security design – junior, mezzanine, and senior tranches. This structure concentrates expected portfolio losses in the junior or first loss position, which is usually the smallest of the tranches but the one that bears most of the credit exposure and receives the highest return. There is little expectation of portfolio losses in senior tranches, which, because investors often finance their purchase by borrowing, are very sensitive to changes in underlying asset quality. It was this sensitivity that was the initial source of the problems in the subprime mortgage market last year. When repayment issues surfaced in the riskiest tranches, there was lack of confidence that spread to holders of more senior tranches. This caused panic among investors and led to a flight into safer assets, resulting in a fire sale of securitized debt. Securitization was initially used to finance simple, self-liquidating assets such as mortgages (Jobst, 2008). But any type of asset with a stable cash flow can in principle be structured into a reference portfolio that supports securitized debt. Securities can be backed not only by mortgages but by corporate and sovereign loans, consumer credit, project finance, lease/trade receivables, and individualized lending agreements. The generic name for such instruments is asset-backed securities (ABS), although securitization transactions backed by mortgage loans (residential or commercial) are called mortgage-backed securities. A variant is the collateralized debt obligation, which uses the same structuring technology as an ABS but includes a wider and more diverse range of assets. The landscape of securitization has changed dramatically in the last decade. No longer is it wed to traditional assets with specific terms such as mortgages, bank loans, or consumer loans – called selfliquidating assets. Improved modelling and risk quantification as well as greater data availability have encouraged issuers to consider a wider variety of asset types, including home equity loans, lease receivables, and small business loans, to name a few. Although most issuance is concentrated in mature markets, securitization has also registered significant growth in emerging markets, where large and highly rated corporate entities and banks have used securitization to turn future cash flow from hard-currency export receivables or remittances into current cash. In the future, securitized products are likely to become simpler. Until the subprime crisis unfolded, the impact of securitization appeared largely to be positive and benign. But securitization also has been indicted by some for compromising the incentives for originators to ensure minimum standards of prudent lending, risk management, and investment, at a time when low returns on conventional debt products, default rates below the historical experience, and the wide availability of hedging tools were encouraging investors to take more risk to achieve a higher yield. Many of the loans were not kept on the balance sheets of those who securitized them, perhaps encouraging originators to cut back on screening and monitoring borrowers, resulting possibly in a systematic deterioration of lending and collateral standards. After years of posting virtually no capital reserves against highly rated securitized debt, issuers are now faced with regulatory changes that require higher capital charges and more comprehensive valuation. Reviving 12

securitization transactions and restoring investor confidence might also require issuers to retain interest in the performance of securitized assets at each level of seniority, not just the junior tranche. Through overaggressive valuation of the underlying assets, securitization led to complex and hardto-value assets being created on the balance sheets of financial institutions. Together with globalization, it led to increasing interconnection of financial institutions and markets, both within and across countries, thus causing leverage to increase within global financial system (Blanchard, 2009; Dodd, 2009).

Africa must therefore put in place proper investor protection laws and antifraud

provisions to discourage the use of inappropriate derivative transactions. Reporting requirements for these derivative transactions must be established to make markets more transparent and endow national and multinational surveillance authorities with greater capacity to detect potential problems before they escalate. In addition, the introduction of new and complex derivatives and their use by firms other than qualified speculators must be regulated through the use of either positive list of acceptable financial instruments or negative list of prohibited ones. The IMF and the Financial Stability Forum, in an analysis of the cause of the financial crisis, revealed shortcomings in risk management practices, and the collective failure to assess and track the degree of leverage taken by a wide range of financial institutions, raising the risk of disorderly unwinding (Sacasa, 2008). Risk management, disclosure, regulation, and supervision did not keep up with rapid innovation, leaving scope for excessive risk-taking and asset price inflation. In particular, such credit was based on wholesale funding without taking into account the consequences of such funds drying up. It is worth noting that financial innovation per se is not a bad thing. Diversification may not be adequate in itself in managing systematic risk. However excessive complexity of such products has not been shown to improve efficiency and welfare benefits. In fact such complex securitization did generate risks. The problem with derivatives is the leverage that goes with it, and the fact that such risk is concentrated on the hands of far too few counterparties. Do our regulators keep track of the leverage taken by financial institutions? For the case of African markets, far too little is being done. Although Kose, et al. (2008) has noted that business cycles may well be converging among developed and emerging market economies, however the two groups appear to be decoupling from each other. Still, it calls for strict regulations governing the leverage of systemically important institutions Africa, with fewer emerging markets. Important lessons for Africa are that market regulation should be designed while considering the inevitability of business cycles and financial crises. Governments should consider the creation of buffer funds during booms to act as cushion during busts. Such a fund should be under government jurisdiction since it is the one that bears the brunt of bailing out institutions. In addition, the size of financial sector to GDP must be continuously checked. Moreover, the size of any single systemically important financial institution must always be tracked and controlled, such that, the bigger the firm, the higher the required core capital.

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3.2. Sovereign Debt Management and Creation of Common Currency The State and Private Sector Debt Burdens There have been arguments as to what ratio of a country’s debt to GDP is optimal. In developing economies, the argument advanced by many analysts is that the average of the debt burdens of other “equivalent countries” is optimal. This is a fallacious argument in light of the sovereign crisis in Europe. This paper argues that so long government debt is to fund viable capital investments; a high debt to GDP ratio is warranted. However if such debt is to be used to fund recurrent expenditure, then even the most minimal of debt is questionable. This is based on the Greek debt crisis. Thanks to the European Central Bank’s lending activities, banks in several European countries can also now borrow more cheaply than their governments. This is ironical given that it was the banking sector’s problems that ushered in the current sovereign debt crisis. Private sector leverage needs to be monitored because when there is default, the debt is usually borne by the government, especially so for systemically important banks. Indeed, investors have learned that simply studying the ratio of government debt to GDP is not enough. Both Ireland and Iceland entered the crisis with very low ratios. But the collapse of their banking sectors meant that private-sector debt was assumed by the government, causing the ratio to balloon (Economist, 2012). Strategies for Preventing Contagion Risk Spread in a Single Currency Area In August 2003, the Association of African Central Bank Governors announced that it would work for a single currency and common Central Bank by 2021 in Africa. The AU’s plan for an African monetary union relies on the earlier creation of monetary unions in its existing regional economic communities like the Arab Monetary Union (AMU); Common Market for Eastern and Southern Africa (COMESA); Economic Community of Central African States (ECCAS), and the Economic Community of West African States (ECOWAS). The East African Community (EAC) is already planning for its currency area. Such proposals are expected to have widespread economic and political consequences throughout the continent, and therefore deserves careful planning and execution in a way that a problem arising from one currency area member does not affect the financial stability of the other member states (Onyuma, 2006), especially during financial crisis. Strengthening the financial system is an important task, irrespective of the emergence of a financial or sovereign debt crisis. Since the financial and economic crisis at the latest, creating a stable and resilient financial system is a matter of global concern. In fact, a number of improvements have already been made in this context. Basel III framework entails extensive new rules for commercial banks (Wyplosz, 2009). The new capital and liquidity requirements in particular can make the banking system more stable. What is important is to implement these new rules at global and at single currency area level and although much has already been achieved with Basel III, a great deal remains to be done. Problem areas include special rules for systemically important banks and the treatment of previously unregulated segments of the financial system, namely the shadow banking system. When 14

these are achieved, then financial distress emanating from one member of the single currency may not result in contagion affecting other currency area members. A stable financial system is a cornerstone of a stable monetary union. In order to get to the heart of the crisis problems, monetary unions needs to be reformed. There are two strategies to a stable monetary union. The first one is strengthening the institutional framework in place beyond what has been achieved to date in many monetary unions. The second strategy refers to the centralization of the fiscal policy – fiscal monetary union within the currency area. Lastly, is ensuring a sustainable sovereign debt levels by currency area member states. Strengthening the Existing Institutional Framework Given the large potential spill-over of national policy failures to the rest of the currency area, the system of mutual surveillance in the currency area must be strengthened rigorously. To prevent contagion risk spread to other countries, both fiscal and macro-economic surveillance have to be strengthened, for instance through more automaticity and less political interference in preventing and correcting unsustainable fiscal policies in member countries. In that way, national autonomy would only be restricted by Union when a country has broken the rules of the game. Given the current financial crisis, it is evident that operating a currency area with many regulators and supervisors as there are member countries is extremely dangerous. In fact, Wyplosz (2009) has maintained that the logic of having a single currency is that the banking system will become increasingly regional, with banks operating across the borders and owned by shareholders from many countries. The implication is that African markets must consider developing single financial sector regulators within each monetary union. Recently, there are plans in Euro Area to harmonize tax rates and retirement age and creating wage indexation. However, there is nothing in the theory of optimal currency areas that calls for harmonising retirement ages and tax rates (Hoogduin, 2011). Therefore, currency areas must avoiding automatic wage indexation. Having mutual recognition of degrees and a legal limit to sovereign debt, can increase fiscal and labour market flexibility and labour mobility, thereby improving the alternative adjustment mechanisms. Given the complexity of solving a sovereign debt crisis in a monetary union with closely intertwined but autonomous countries, prevention remains infinitely better than the cure. The challenges to cope with therefore include restoring fiscal soundness and drawing all the right lessons from recent global financial crisis. Others are further improvement of the single market with a single currency through structural reforms and improved governance. There exists frequently expressed fear that the present institutional framework in currency areas experiencing financial crises is unsuitable for monetary unions. This is true for three reasons. First, the no bail-out principle has to be expressly reaffirmed whenever there is debt crisis. Investors in the financial markets will sanction misguided fiscal policy in a timely fashion only if they stand to lose

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money if they do not. Of course, this presupposes that the regulation of the financial markets offers incentives for risk-conscious behaviour (Crockett, 2009). Second, there are needs for a much greater automatism in the regulators for imposing sanctions when the deficit and debt limits are breached. Yet this is precisely what is missing from the latest resolutions aimed at reforming the financial regulators within the Euro area. For instance, the automatism in Europe does not yet go far enough as there are still too many exceptions and too much scope for political interference. It seems sinners are still passing judgment on other sinners. In principle, many regulators have been given more bite, but it remains questionable whether politicians will let the off the leash when push comes to shove. Third, monetary union needs a permanent crisis mechanism, which could be brought into play in the event of a crisis that threatens financial stability throughout the currency area. However, financial assistance for individual countries must be tied to strict economic and fiscal policy conditions; assistance must be made subject to appropriate interest rate premiums; and private creditors must be involved should the country in question default. Above all, a crisis mechanism must not be used to brush aside important principles under the smokescreen of safeguarding financial stability. These principles include subsidiary, individual countries’ responsibility for their own fiscal policy and the no bail-out principle. Against this backdrop, a critical view has to be taken by currency area’s heads of states. The first problematic aspect is that conditions for granting emergency loans are usually loosened. They are more favourable than those borne by some of the countries providing assistance when they tap the capital market. But the less a country has to pay for assistance, the smaller, is its incentive to consolidate its public finances and return to the capital markets. Adopting these conditions also for future aid programmes or even for the permanent crisis mechanism can perpetuate the problem. A second problem is that government bonds may be purchased on the secondary market through the crisis mechanism in future. If bonds of countries without an assistance programme are purchased, it is unclear how consolidation and reform conditions can be enforced. Nor is it clear how this squares with the requirement that assistance can only be granted if the stability of the entire monetary area is under threat. Ultimately, therefore, the possibility of secondary market purchases undermines the incentives to pursue a sound budgetary policy. Moreover, secondary market purchases are a very crude and a rather ineffective instrument for stabilising the financial markets and influencing countries’ funding conditions. Thus, much larger amounts are needed to achieve a particular result. This increases the risk for the taxpayers of the countries providing assistance. A third problem is that of leveraging the crisis mechanism. Proposals of this kind are closely linked to the secondary market purchases. There must be sufficient funds for the classical instruments of the rescue shield – direct emergency loans to individual member states. However, all the parties concerned ought to realise one thing. Leverage constructions increase the risk for the taxpayer – the relationship between leverage and risk is one of the first lessons from the recent financial crisis. What 16

in any case must be rejected is a leveraging by granting the rescue outfit a banking licence, which would allow it the tools to engage in whole monetary regions refinancing operations, to borrow directly from central banks. For then, the currency area would largely be unable to shape monetary policy autonomously. Indeed, the rescuing outfit would be able to generate a virtually unlimited flow of funds to the capital markets and shift risks around between member states by purchasing large quantities of sovereign bonds. With that, Dombret (2011) has also argued that the ban on monetary state financing set forth in the EU treaties would be well and truly violated. Overall, the question that presents itself is: how is a sanction mechanism – no matter how severe – in the tools supposed to prevent unsound fiscal policy if threats of sanctions are made, yet favourable conditions are lavished on a country that continuously disregards the rules? This is a question of fundamental importance to monetary unions. Whether the answer proves convincing will depend on what appear to be purely technical aspects of the solution, since they can have unexpected implications. One example concerns the choice of top rating for the bonds (like triple-A) with which the rescue fund borrows money on the capital market for the assistance programmes. This top rating ought to remain intact as long as the borrowing by the crisis rescue outfits does not exceed the guarantee amount of the liable countries that are top rated. In connection with the call for additional funds for rescue, insistence on this top rating for currency area bonds leads, however, to the above problematic leverage tool. On the other hand, abandoning the top rating would also enable the crisis rescuer to lift its lending volume. It important to note that the crisis rescuer lending volume must be large enough reverse the contagion. In contrast to a leveraging, however, the risk borne by the taxpayer would be lower if the top rating is dispensed with. If the currency area bonds have a somewhat lower rating, the effect would be to an increase in the rescuer’s funding costs. However, these costs would be borne by the countries receiving assistance. This would solve, at least in part, the problem entailed in loosening the conditions for emergency loans and raise the incentive for countries to return to the capital market under their own steam. Strengthening the existing regulatory framework is a feasible path towards stabilising monetary unions. However, that can only work if the rules are designed in such a way that they do not leave the door wide open for misguided incentives. This applies in particular to the crisis mechanism – both at the conceptual level and in terms of the technical implementation. Designers of currency areas in Africa must therefore give regulatory framework a thorough consideration, or else, should financial crisis emanate, the speed of its spread will be alarming. And given the experience in the Euro area, the selection of neighbours into the common currency area is as critical as ensuring financial discipline by the same neighbours. In sum, having all these tools in place implies that should a financial crisis occur, the post crisis financial world is likely to be characterized by enhanced multilateralism, greater policy coordination, and a more effectively regulated financial system. Lipsky (2009) has also maintained that the IMF must be prepared to play a key role in this new global environment implying it must have the necessary tools and resources to fully meet the challenges this new role implies. 17

Ensuring Sustainable Sovereign Debt In order to contain impact of debt crisis, regain investor confidence and solve the underlying failures which led to the crisis. International donors must consider crisis lending to currency area governments based on strong conditionality. For instance, in troublesome Euro Zone members, like Greece, Spain and Ireland, the adjustment towards a sustainable government debt path is currently being made with the help of an external financial assistance programmes. However, such programmes must rely on very strong fiscal frontloading and comprehensive and far-reaching structural reforms which, also include measures aimed at an overhaul of the banking sector. These programmes aim to correct the divergences which have accumulated over the past decade. Furthermore, governments must issue plans to strengthen the system of fiscal and macroeconomic surveillance in the monetary union. The common central banks must address the severe tensions in financial markets by purchasing debt securities in certain market segments which are dysfunctional. The objective of this temporary securities markets programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. African governments planning a currency area must work on comprehensive packages to address any emerging crisis, since getting in front of the crisis would indeed be much more effective than following a piecemeal approach once the crisis has already began. The decision to create a permanent regional stability mechanism must not be implemented too hastily, or else the implications for the functioning of monetary union would not be clear. Within all these, the option of sovereign debt restructuring must be explicitly addressed. However, the restructuring of sovereign debt is a major event, with large confidence and potential contagion effects. It should therefore be considered only as an ultimate solution, when there are no other options left. To prevent the perception that currency area sovereign debt can be restructured more easily than the debt of other countries, it is vital that the established IMF practices are followed when it comes to crisis lending and debt restructuring. To this end, the IMF should be fully involved with any crisis lending to and debt sustainability analysis of currency area countries. Policy makers in some African regions maintain that a single currency is viable only if there is a full fiscal union or even a political union. This is the basis for the proposal to create a federal government within the EAC. Although a political union would certainly solve the problem, however, it is not necessary. We believe it would be enough if the rules of the game were respected, as they are originally intended when the currency union is designed. This does call for some major changes with regard to the governance of individual countries and of the monetary union as a whole. Most importantly, national policies need to be adjusted and national policy frameworks need to be reformed as to guarantee sound and sustainable policy decisions. This reflects the fact that the sovereign debt crisis has its roots in national policy failures. It also reflects the fact that the huge adjustment costs are mainly borne by the residents of the countries involved. 18

Many African economic regions are currently creating or planning common currency areas. However, existing evidence suggest that countries within these regions differ in terms of regulation, facing asymmetric shocks and different production structures (Kishor and Ssozi, 2009; Rusuhuzwa and Masson, 2012). Countries have had difficulty meeting convergence criteria, most seriously as concerns fiscal deficits. Therefore, preparation for monetary unions in Africa will require effective institutions for macroeconomic surveillance and enforcing fiscal discipline. And, euro zone experience indicates that these institutions will be difficult to design and take a considerable time to become effective. This suggests that a timetable for monetary union in the EAC and other African regions should allow for a substantial initial period of institution building. In order to have some visible evidence of the commitment to monetary union, in the meantime African economic regions like the EAC, may want to consider introducing a common basket currency in the form of notes and coin to circulate in parallel with national currencies.

Creating a Fiscal Union within a Currency Area The second path towards a stable monetary union is by way of a fiscal union. This would not automatically lead to a completely centralised fiscal policy. But it would be important to set, at currency area level, strict deficit and debt limits for national budgets. These limits would then apply at all national levels. This means both at central, state and local government and the social security systems. The currency area rules must be combined with appropriate powers of intervention, as only then can the rules be effectively implemented. If the national levels breach the stipulated deficit and borrowing limits, they would have to forfeit their fiscal sovereignty. The final decision-making powers over budgets would then no longer rest with the national parliaments but would be transferred to the whole common currency level. Ultimately, fiscal union would constitute a consistent framework for the single currency, although to implement it would necessitate extensive changes to the common currency area treaties and national constitutions. This is a long route and there is no telling whether the people of the currency area would support it. A fiscal union of this kind could, in principle, work without a joint liability (Onyuma, 2006). Although joint liability could be introduced without much difficulty, it is not necessary. On no account should joint liability be introduced after the crisis has begun in mere anticipation of fiscal union. This would be taking the second step before the first, and inevitably entail the risk of stumbling. Instead of offering a consistent solution, this would mean pursuing a middle path on which liability would be increasingly communalised while fiscal policy remains a national responsibility. That path entails obvious contradictions but one which can be considered by Africa. Besides a swift and ambitious fiscal consolidation, there must be clarity regarding sovereign debt defaulters. They must fulfil the conditions of the financial assistance programme; if they don’t, there is no basis for granting further support to them (Eichengreen, 2009). Such scenario cannot therefore be categorically ruled out, given Greece’s experience in the EMU. This calls for clarity regarding the 19

banking sector’s resilience. It has to be strengthened where it is too low in order to prevent contagion effects. This explicitly includes recapitalisations. This is justified even though the banks are not to blame for the high level of sovereign debt in several European peripheral countries. There is also the need for clarity regarding the future of the monetary union. Schaechter et al. (2012) have assessed the nature of fiscal rules being developed in response to the current global financial crisis and found that many new fiscal rules have been adopted and existing ones strengthened; and the number of fiscal rules and the comprehensiveness of the design features in emerging economies has caught up to those in advanced economies. Therefore, for Africa, the nextgeneration fiscal rules will need to be more and increasingly complex combining the objectives of sustainability and with the need for flexibility in response to shocks, thereby creating new challenges for implementation, communication, and monitoring. We have proposed three different paths for consideration, but as to which of the three paths to be chosen is in the hands of the currency area policy makers in Africa. Since countries are increasingly using products of financial innovation to exceed agreed upon debt limits, the use of such instruments must be properly regulated and the overall debt level must also be caped, irrespective of use or non usage of financial engineering tools. This can be achieved by ensuring that countries under a currency bloc issue common bonds instead of each country issuing own treasury bonds and bills. This way the monetary union is able to track and sanction countries exceeding the set debt limits. Belka (2009) has suggested the need for issuance of solidarity bonds within a currency area for national financing. In addition, Claessens et al (2012) have also discussed the proposals for common Euro area sovereign securities and concluded that such instruments can potentially serve two functions: in the short-term, stabilize financial markets and banks and, in the medium-term, help improve the currency area economic governance framework through enhanced fiscal discipline and risk-sharing. However, many questions remain on whether financial instruments can ever accomplish such goals without bold institutional and political decisions, and, whether, in the absence of such decisions, they can create new distortions.

3.3. How Can Africa Predict Occurrences of Business Cycles and Financial Crises? Globalization normally makes it easier for firms to raise cheap capital beyond their boarders (Onyuma, et al 2012). It increases cross border capital flow causing global imbalances. This leads to depressed interest rates in markets. Due to the low cost of credit, there emerges excessive risk taking by global investors. Since borrowing can be done to obtain more credit, this leads to too much money in the economy chasing too few goods and securities. Consequently, as shown in Figure 1 below, inflationary pressures create asset bubbles. The bubble then bursts triggered, in this case, by default on subprime mortgages, and the cycle repeats itself again.

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Increased cross border capital flows

Globalization

Bubble Burst, triggered in this case by default on subprime mortgages

Global Imbalances

Too much money chasing too few goods: Inflationary pressure creates asset bubble

Depressed Interest ratesThe Conudrum

Low cost of credit: Excessive Risk taking

Source: Authors’ Conceptualization from Literature. Figure 1: The Evolution Cycle of a Financial Crisis Then, how can Africa financial markets and institutions predict the occurrences of economic and financial crises? Business cycles and financial systems crisis seem to reinforce each other during crisis. Even without crisis, the two create asset bubbles that precede crisis. Indeed, the global financial crisis looks like it is passing, and the priority in policy making should be on how to reduce the regularity of its recurrence and its severity in future. Naes et al (2011) have done analysis of business cycles and financial crisis and conclude that they are predictable. Their findings suggest that liquidity of the securities market is strongly correlated with business cycles, and investors’ portfolio compositions change with the business cycle and investor participation is related to market liquidity. Thus, systematic liquidity variation is related to a flight to quality or flight to liquidity during economic downturns. Securities market liquidity is an excellent indicator of the real economy. The reinforcing mechanism between financial market and the economy leads to the worsening of an economic crisis, or to the build up of asset bubbles. The flight to quality takes the form of investors reorganizing their portfolios in favour of large caps. Consequently it is the liquidity of the small and medium caps stocks that is most useful in prediction. As such, regulators should be concerned about stock market liquidity, and appropriate monetary and fiscal policy interventions put in place when observed stock market liquidity falls below the acceptable thresholds. At present and in the past, the regulators have largely been concerned with listed companies, for example, observing the laid down rules and regulations, which in or opinion is not the primary objective of regulation. Regulation is meant to primarily maintain stability in the 21

economy by ensuring a strong, and stable financial system. Maintaining stability is not synonymous with ensuring financial institutions toe the line by applying a checklist approach to regulation. Rather, the regulator should take proactive steps to ensure such stability. Developing a power to predict chaos would be a major addition in the arsenal to fight future crisis. African stock market regulators should develop a dashboard to capture the trends in stock market liquidity, and be able to inform fiscal and monetary policy making decisions at the Macroeconomic level. This however, would call for greater cooperation between the security market authorities and the relevant policy making bodies, like the central banks and treasury, and other financial system regulators in the form of an independent committee specifically charged with macro-prudential regulation to ensure more effective, coordinated actions and expand the cross institutional scope of regulation. In Kenya, for example, the central bank and the treasury are represented on the board of the capital markets regulator, but the regulator is not represented in the policy making organs. Given this current arrangement, we advocate for African capital markets regulators to be made part and parcel of all domestic financial and economic policy organs. At a minimum, the regulators and the policy making and implementing organs should have greater cooperation than they presently have because the central banks are meant to foster the liquidity, solvency and proper functioning of a stable market- based financial system. Without proper prediction tools such as the one suggested below, this mandate may remain a mirage. Bhatia and Bayoumi (2012) have questioned the view that leverage should have forewarned us of the global financial crisis of 2007–09, pointing to several gearing indicators that were neither useful portents of the onset of the crisis nor of its ferocity. Instead they found that the use of ill-suited collateral in the secured funding operations of U.S.-based investment banks was the fatal link between the collapse of structured finance and the global malfunction of funding markets that turbocharged the downdraft. However, the history of economic growth has shown remarkable patterns of booms and busts (Boretos, 2011). The historical based model predicted the next crisis to happen in 2013, an acceptable error margin, given that the crisis unfolded in 2008 in USA and continues to date in Europe. A few days before the collapse of the Lehman Brothers, Boretos (2008) predicted an upcoming economic downfall, near the end of the first decade of the millennium. The analysis was based on a simple logistic growth fit against world real GDP data. According to this model, the global economy follows a two-century GDP growth wave, from 1917 to 2112, attributed to globalization. This is evident in Figure 2 below.

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Source: Boretos (2011). Figure 2: Two Century World GDP Growth Wave and Seasons This period is equally divided into five phases called seasons that last nearly 40 years and constitute successive periods of growth, saturation, and decline. Almost every forty years, near the middle of each season, there is a peak point that initiates a cyclical slowdown of the global economy. This is evident in Figure 3 below. The cyclical downtrend occurs when the economy overshoots – when the ratio between actual and estimated GDP is at maximum. The first two cyclical slowdowns occurred at 1937, near the start of World War II and at 1975, near the outburst of the oil crisis. The next cyclical peak point occurs at 2013, very close to the 2009 global economic crisis. In our opinion, there are two options concerning this forecast: either the cyclical downturn occurred at 2009, an acceptable 4 year error in the two century growth process, or we haven’t seen the worst of the recession yet. Are we likely to witness another crisis by 2013? Absolutely since the current sovereign debt crisis within the Euro region is likely to spread worldwide, even reaching Africa.

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Source: Boretos (2011). Figure 3: Cyclical Patterns in World GDP and Financial Crisis The problem with financial crisis and business cycles is not their occurrence, but rather the lack of proper tools to forecast and mitigate them. Even with reasonably accurate forecasting tools, there still lies the problem of convincing powers that be to undertake policy actions to mitigate crisis especially at a time when the economy and financial markets are booming and when deemed to be against prevailing political interests. In fact, there had been warnings about the financial crisis as far back as 2004 most of which went unheeded. Unfortunately, the central banks in developing countries such those in Africa, do not have robust approaches for forecasting financial crisis!

4. Conclusions and Policy Considerations The Global financial crisis and the sovereign debt crisis in Europe have brought to the fore questions regarding the suitability of the current risk management models and the regulatory framework. The two have highlighted just how vulnerable the financial sector, including the core of the payment system, is to external shocks. The financial crisis saw liquidity in the stock market drying up as a precursor to the crisis in the real economy. We argued that there is a strong relation between stock market liquidity and the business cycle. As such, regulators should be concerned about stock market liquidity, and appropriate monetary and fiscal policy interventions put in place when observed stock market liquidity falls below the acceptable thresholds. Stock market regulators should develop a dashboard to capture the trends in stock market liquidity, and be able to inform fiscal and monetary policy making decisions at the macroeconomic level. This call for greater cooperation between the

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capital markets regulators and the relevant policy making bodies such as central banks and the treasury. The eligibility of countries forming common currency areas has also been put to test. This article has emphasised the need for a relooking at how risk is assessed, government debts managed, and how to manage the transition to common currencies in economic blocs. With African Union considering the creation of a monetary union, the paper highlights some pitfalls that should be avoided and how the regions should go about introducing the common currency. The paper recommends a relook at the risk free concept, and suggests that with assets in a portfolio (including government debt) being inherently risky, portfolio risk measurement models should be reviewed. We also argued that business cycles are inevitable is a fact that we have to contend with. This calls for the need to predict the occurrence of business cycles and financial crisis. For Africa, we must rebuild our financial architecture to provide better regulation which can rapidly identify emerging vulnerabilities, that can properly price risk, and that strengthens incentives for prudent behaviour. We must widen the regulatory net to cover all those who need to be regulated including, hedge funds, private equity funds, mutual funds, investment banks, mortgage originators, clearance and settlement systems, credit rating agencies and audit firms. We must reset our financial regulation to include supervisory techniques that counteract the tendencies to misprice risk and to take on excessive leverage. The financial sector regulators also need to be reorganized for better coordination at domestic, regional and global levels. All these call the need to strengthen the ability and willingness of regulators to enforce new regulations. This will definitely require ensuring operational independence and adequacy of resources. There is the need to design market regulation while considering the inevitability of business cycles and financial crises. African countries must create a buffer fund during booms to act as cushion during busts. This cushion fund should be held by government since it is the one that bears the brunt of bailing out institutions. In addition, the size of financial sector to GDP must be continuously checked. Moreover, the size of any single systemically important financial institution must always be tracked and controlled, such that, the bigger the firm, the higher the required core capital. Financial crisis in financial markets was the result of three failures: a regulatory and supervisory failure in advanced economies; a failure in risk management in the private financial institutions; and a failure in market discipline mechanisms. Due to the lessons learned from the current financial crises, Africa must now develop the economic tools to be able to emerge from any emerging financial crisis with its economies and societies intact. Preventing occurrence of these failures requires an international effort, because borders do not confine financial institutions or keep out financial turmoil. Although not all African countries need to have the same policies, but they must all talk to each other about their policies, and consider the effects of their actions on their partners. Coordinated continental or global action has the power to reverse the tide of the financial crisis, but governments also must be ready to deploy all instruments to 25

limit damage to the real economy. It must be noted that actions in the financial markets are essential, but they may not be sufficient. African countries must be ready to deploy all of the instruments of modern macroeconomic policy to limit the damage to the real economy, in the face of the crisis. The article has presented approaches which can be used by African markets, regulators and investors to predict the emerging business cycles and eminent financial crisis. The specific path chosen by policymakers should allow for learning and secure the necessary evolution of institutional infrastructures and political safeguards. REFERENCES Adler, G. (2012) Intertwined Sovereign and Bank Solvencies in a Model of Self-Fulfilling Crisis. International Monetary Fund Working Paper, No.12/178. IMF, Washington, DC. Bebchuk L., F. J. (2004). Pay Without Perfomance. Cambridge, Mass: Havard University Press. Belka, M. (2009) Europe Under Sress. Finance & Development , 46 (2), June, pp.8-11. Berglof, E., Plekhanov, A., and Rousso, A. (2009) A Tale of Two Cities. Finance & Development, Vol. 46 (2 June): 15-18. Bhatia, A. V. and Bayoumi, T. (2012). Leverage? What Leverage? A Deep Dive into the U.S. Flow of Funds in Search of Clues to the Global Crisis. International Monetary Fund Working Paper, No.12/162. IMF, Washington, DC. Blanchard, O. (2009) The Perfect Storm: Blanchard View of the Underlying Cause of the Crisis. Finance & Development , 46 (2), June, pp.37-39. Bloomberg. (2011). IMF's Largade Warns of Risk of Lost Decade. Available online at http://www.mobile.bloomberg.com/news/2011-11-09/lagarde-sees-lost-decade-for-world-economyunless-nations-act-together.html. Boretos, G. P. (2008) The Future of the Global Economy. Technological Forecasting & Social Change, Vol.76(3):316-326. Boretos, G. P. (2011). Global Economic Crisis: Could we have Predicted It? Available online at http://www.forecastingnet.com/apps/blog/entries/show/7679507-global-economic-crisis-could-wehave-predicted-itBoughton, J. M. (2009) A New Bretton Woods? Finance & Development , 46 (1), March, pp. 4446. Chan-Lau, J. A., Liu, E. X. and Schmittmann, J. M. (2012) Equity Returns in the Banking Sector in the Wake of the Great Recession and the European Sovereign Debt Crisis. International Monetary Fund Working Paper, No.12/174. IMF, Washington, DC. Choudhry, M., & Landuyt, G. (2010). The Future of Finance: A New Model for Banking and Investments. Hoboken, New Jersey: John Wiley & Sons, Inc. Claessens, S., Mody, A. and Vallée, S. (2012) Paths to Eurobonds. International Monetary Fund Working Paper, No.12/172. IMF, Washington, DC. Crockett, A. (2009) Rebuilding the Financial Architecture. Finance & Development , 46 (3), September, pp. 18-19. Dell’Aricca, G. (2009) Asset Price Booms: How can they Best be Managed? Finance & Development , 46 (2), June, pp. 34-36. Docking, D. S. (2012) Déjà Vu? A Comparison of the 1980s and the 2008 Financial Crises. Journal of Business Economics & Finance, Vol.1, No.1: 17-29. Dodd, R. (2009) Playing with Fire. Finance & Development , 46 (2), June, pp.40-42. Dombret, A. (2011). Quo Vadis Euro Area? Challenges Facing Monetary Union. Berlin: Speech delivered to the CDU Economic council. Economist (2012). Sovereign Bonds- Oat cuisine- A stodgy Asset Class has Become More Complex and more Dangerous. The Economist , pp. 80-82, February 11th Issue. 26

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