Strengthening Capital Market Regulation

Goddy Egene writes that the frameworks for risk based supervision and systematically important financial institutions introduced by the Securities and Exchange Commission will bolster operations in the nation’s capital market

The Nigerian capital market has continued to suffer the negative impact of the global financial crisis   of 2009.  Since that crisis, the market is yet to recover and enjoy high patronage as many investors remained dazed by the losses they suffered. In fact most investors have vowed not to return to the market. However, regulators and some stakeholders have been making efforts to regain the confidence of investors.

As part of those efforts, the Securities and Exchange Commission (SEC), which is the apex regulator of the capital market, has moved to strengthen the regulation of capital market operators (CMOs). This it has done with the introduction of risk based supervision (RBS) framework and the framework to identify systemic non-bank financial institutions (NBFI) last week.

 Risk based supervision framework

The RBS framework, which has already been approved by the Minister of Finance, Mrs. Kemi Adeosun has come in a very good time and that is the focus of most regulators globally. The overall objective of the RBS is to ensure the safety and soundness of Capital Market Operators (CMOs) by adopting a proactive risk based supervisory process that centres on risk profiling of a CMO and implementing appropriate supervisory methods that are commensurate with risks identified in the business operations of a CMO. This serves to ensure that regulatory resources are optimally allocated according to the risk profile of a CMO.

Before now, the regulatory environment in the Nigerian financial market has traditionally been focused on a supervisory process that is compliance based or ‘Rules Based’ supervisory regime. This regulatory approach tends to excessively focus on monitoring and ensuring compliance with laid down Rules and Regulations.

But in recognition of the obvious limitations of a rules based supervisory regime, a global trend towards a risk based supervisory model that focuses on identifying, monitoring and mitigating risk, signifies a major paradigm shift in the approach to regulating financial markets.

Adopting RBS not only ensures that regulated entities are well positioned to accommodate the risks that they bear, but more importantly absorb risks that may crystallise from adverse events. This ensures that potential spillover effects are isolated with limited externalities on the financial system.

In fact, the International Organisation of Securities Commissions (IOSCO) emphasises the importance of securities regulators to adopt RBS regime and this is prominently featured as one of the IOSCO’s principles of regulating market intermediaries.

And in recognition of the importance of RBS, and to align its oversight functions with global trends and the guiding principles of the IOSCO, SEC has adopted RBS into its supervisory process.

“This is to ensure that regulatory oversight is more effective, investor protection is advanced and systemic risk is mitigated,” the Director General of SEC, Mounir Gwarzo stated.

He noted that this framework is a dynamic working document that will be reviewed on a regular basis and as the need arises to ensure that it remains relevant in achieving the supervisory objectives of the commission.

 As part of the adoption process, a RBS framework has been developed to serve as a guide for staff of its inspectorate division and would apply to the prudential supervision of all CMOs.

Evaluating inherent risks

Under the RBS, the evaluation of risk mitigating features of the CMO will be determined by a review and assessment of the quality of risk management control functions. According to SEC, the RBS process, contemplates the reliance on the opinion of external auditors for the fairness of the financial statements of a CMO. This shall be used to modify the scope of reviews and minimize duplication of effort.

Communication of findings and recommendations to the subject CMO will be timely and the degree of SEC’s involvement and engagement with the CMO will be commensurate with its risk profile. Ratings will be provided   and discussed with the CMO after each review.

Also, the RBS highlights a risk assessment summary which would indicate the risk profile of a CMO and would serve as the basis for allocating regulatory resources for ongoing monitoring and supervisory efforts.

 Framework for SIFI regulation

The essence of identifying certain institutions as systemically important can be traced back to the events of the 2007/2008 global financial crises, when the financial distress and collapse of certain financial institutions termed as ‘too big to fail’ prompted most governments around the world to provide substantial bail out measures for these financial institutions. The bailout measures were aimed at restoring stability in the financial system and limiting the undesirable externalities that such failures could pose to the real economy. The economic cost of these bail out measures and the associated moral hazard, have warranted the need for regulatory reforms that address the potential risks and negative externalities that could emanate from the failure or distress of a financial institution that is identified as systemically important.

To address these challenges, SEC in line with global initiative, has developed methodologies aimed at identifying systematically important banks, insurers and other financial institutions in the country whose failure could threaten financial stability.

A systemically important financial institution is any institution whose distress or disorderly failure, because of its size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.

Gwarzo noted that in identifying a systematically important operator, the Commission would enhance its regulatory supervision through on-site inspections to monitor the compliance level of operators.

 Objectives of the framework

The commission said the overarching objective of this framework is to promote the safety and soundness of SIFIs that are under its regulatory purview, by identifying and militating against the adverse effects that the failure of such institutions could have on the Nigerian financial system and real economy as a whole.  Particularly, the framework seeks to achieve: the adoption   of appropriate quantitative and qualitative methodologies for identifying SIFIs that are under the regulatory purview of the Commission; addressing  the systemic risks and associated moral hazard of institutions that are seen by the markets as too big to fail; reducing  the probability of failure of a SIFI by subjecting such institutions to increased regulatory scrutiny and higher requirements for loss absorbency and reducing the potential contagion effects that could arise from the failure of an institution as a result of its interconnectedness with other financial market participants.

  Spreading distress

Three channels  have been identified through which the financial distress of a Non Bank Non-Insurer Globally Systemic Financial Institutions (NBNIs) financial entity can be transmitted to other financial firms/markets and as such present a potential risk to the stability of the financial system. These channels are: The first is the exposures/counterparty channel, which is the impact  that a systemic institution’s failure may have on its creditors, counterparties, investors, or other market participants, which may result in a broader financial crisis if their linkages and exposures are significant.

Another channel is asset liquidation/market, which is the impact a systemic institution’s failure may have on asset prices, if it is forced to liquidate assets quickly, thereby distorting trading and provoking losses for other market participants with similar holdings. The risk associated with this channel is amplified with an entity’s use of leverage.

Also there is the critical service channel. This is the impact that a systemic entity’s failure may have on the market, if it provides a critical function or service that market participants rely upon for which there are no available substitutes.

 Identifying capital market operators

In order to manage the potential systemic risks posed by NBNI financial institutions that are identified as systematically important in the market, the commission said it would take certain the following steps.

Capital requirements   

According to SEC, systemically important CMOs would be subjected to higher capital requirements that are commensurate to their size, scale of activity and inherent risk.  SEC said it shall on a quarterly basis review the capital adequacy status of the identified CMOs with a view to ensuring that the capital requirements are within the regulated level.

 Legal entity identifier system

Identified CMOs shall be required to enroll for Legal Entity Identifiers (LEI) system at the Central Securities Clearing System (CSCS). LEIs are unique identification associated with a single legal entity, which allows for consistent identification of parties to financial transactions, facilitating a consistent and integrated view of exposures. LEIs are essential for effective risk management for financial companies, especially for assessing their connections and exposures to other firms and regulatory oversight. The LEI can help the financial industry, regulators, and policymakers trace exposures and connections across the financial system.

 Effective recovery system

Identified CMOs should be required to carry out a test of business continuity plan and data recovery systems twice a year to assess and check resolvability issues where applicable and a report submitted to the Commission.  Accordingly, SEC shall verify the tests results during inspection.

Enhanced disclosure requirements

In addition to the existing disclosure requirements, identified CMOs would be required to ensure greater information disclosure with particular emphasis on indebtedness and counterparty exposures to similar SIFIs and other market operators. Also, they would be required to limit their total exposure to individual counterparties.

Enhanced regular supervision

The SEC shall ensure comprehensive on-site inspection twice in a year on identified CMOs. There would  be a monthly disclosure of compliance level with the framework to be submitted to the SEC. The monthly disclosure would enable the SEC monitor compliance ahead of the statutory quarterly rendition of returns.    Besides, SEC shall collaborate with the relevant self regulatory organisations/trade groups in the regulation of the identified CMOs and ensure that the firms operate within the scope of acceptable principles of regulatory compliance.