A structural review of capital market operators

1. A structural review of capital market operators

2. Introduction Let me first start by commending the Securities & Exchange Commission and the Central Bank of Nigeria under the vision 2020 work done in time passed under the Money & Capital Markets Committee in its bold accomplishment of ending the concept of universal banking and hence, the final separation of commercial and merchant/investment banking. However, this major accomplishment has led to a major financial exclusion of the key players in this very important intermediation sector of the economy FMD DISCUSSION PAPER 2

3. We are not investment banks – we call ourselves that but, we are not. • There are two types of intermediation; • Bank based intermediation and • Capital market based intermediation – • In Nigeria, only bank based intermediation works - Our inability to provide a full platter of services to our clients and fulfill our role as intermediaries is a testimony… • 2. Why? capital market based intermediation is cut out of the wholesale funding markets hence, no ability to fund any part of the capital market business, it has no repo markets for liquidity, and therefore (except for commercial bank treasuries) generally has inefficient sales & trading operationsor maturity transformation activities. • 3. There is therefore no real added value from a liquidity stand point, as the equity trading business is generally also mainly brokerage hence, market making which is meant to significantly increase liquidity is highly inefficient. FMD DISCUSSION PAPER 3 3

4. We are not investment banks – we call ourselves that but, we are not….cont’d • Even from the corporate finance origination stand point; • Underwriting financing (if you can get it) is extremely high, • No ability to execute bought deals for sell down, • No real leverage at the client’s table - lack of balance sheet generally (application to stand-alone institutions). FMD DISCUSSION PAPER 4

5. We are not investment banks – we call ourselves that but, we are not…..cont’d • The question is: • How long can these businesses continue to mal-function due to their inability to operate as intermediaries across the financial markets with No wholesale funding access? • As is, capital market operators currently operate in “silos” with no access to the money markets and therefore totally cut off from the life blood or base liquidity of all financial markets. FMD DISCUSSION PAPER 5

6. Nigeria and Malaysia comparison FMD DISCUSSION PAPER 6

7. Malaysia and Nigeria – A factual Comparison of capital requirements - 1 FMD DISCUSSION PAPER 7

8. Malaysia and Nigeria – A factual Comparison of capital requirements - 2 FMD DISCUSSION PAPER 8

9. Malaysia and Nigeria – A factual Comparison of capital requirements - 3 FMD DISCUSSION PAPER 9

10. Malaysia and Nigeria – A Comparison –Key Takeaways • The new SEC capital requirements are adequate for the current size of the economy ` BUT • The capital requirements for a Merchant Bank by CBN is clearly in excess for the size of our economy FMD DISCUSSION PAPER 10

11. Malaysia and Nigeria – A Comparison – Key take aways..cont’d • Best case example, Commercial Banks in 2004 where asked to increase capital from N2bn to N25bn to become universal banks – this was severely frowned upon by the market as it was a 12.5x increase in capital • An issuing House/Financial Adviser, Underwriter, Asset Management License from SEC was until recently N270m – (their combined work however constitutes c50% of the current Merchant Banking License issued by CBN) • Hence on September 7th 2010 when the Merchant Banking regulations were signed by the CBN, capital market operators wising to convert (who were not officially made aware of this licence that constitute c50% of the allowable business) were expected to increase from N270m to N15bn - a Whooping 55.6x INCREASE IN CAPITAL. FMD DISCUSSION PAPER 11

12. Approach to our Operations and Regulations • This has not been possible. As to date (26th of March, 2014) there remains only one fully owned Nigerian merchant bank after c4years!! • This means we require a new way or approach to our operations and markets – not in regulatory and operational silos but across the full curve from the shortest end to the longest (permanent capital or equities)…see fig 2 • We therefore require a new paradigm shift in thinking and make some major changes to the way we operate and regulate our markets • The first being - like other liquid markets (Malaysia included)…….. • ….THE CENTRAL BANK MUST JOINTLY WORK WITH THE SECURITIES EXCHANGE TO GROW AND REQULATE THE INDUSTRY - WHY? FMD DISCUSSION PAPER 12

13. Addressing the NEED for a WHOLESALE FUNDING MARKET • ALL IMPORTANT LIQUIDITY • “The tri-party repo market is the most important source of funding for investment banks and securities broker-dealers as they can obtain short-term liquidity to finance their securities portfolios. Liquidity providers are usually money markets, investment funds, asset managers or public authorities with surplus liquidity” - Deutsche Bundesbank Monthly Report Dec 2013. • TODAY in Nigeria 2014 – this resides ONLY at the short end of the curve (Money and Interbank Markets plus the discount window – Lender of last resort – comfort to all investors) • No Broker/Dealer/Market Maker has access to this and therefore the business is severely illiquid, fragile, small, viewed as high risk and can NEVER grow into real institutions FMD DISCUSSION PAPER 13

14. Possible Suggestions • We therefore suggest one or a combination of the following options :- • Adopt the Malaysian model of a Universal Broker • A Financial Market Dealer licence that will support financial market intermediation to act as a stop-gap measure to operators becoming a full fledged Merchant Bank (jointly regulated by SEC and CBN) • A two-tier Merchant Bank Licence • International Merchant Bank License • National Merchant Bank License • Each position is discussed in-turn in exposition to follow... FMD DISCUSSION PAPER 14

15. DMB Money Markets Short Term Capital Background to our Market D.H D.M.B D.H Bond Markets Medium Term Capital NBFI* brokers I.H The Nigerian capital market operates in silos of its own, cut off from the rest of the financial markets. We currently have a market that looks as follows:- NBFI Broker/Dealer Permanent Capital Equity Markets Issuing houses Fig 1 FMD DISCUSSION PAPER 15

16. Background Risk Premium Risk Premium Risk Premium If we plot these markets in risk/return/duration space, we should get:- Equity Markets Bond Markets Money Markets Fig 2 FMD DISCUSSION PAPER 16

17. Background In effect, for the same credit risk, the cost of shorter term money should by all definition be cheaper than longer term capital or permanent capital. “A normal yield curve” So, whose responsibility is it to price the entire financial markets as depicted in fig 2 appropriately? Different parts of the market are concentrated in silos and there is no one institution that can design/create, price and trade across instruments across the curve Our competitive ability should be to fully serve our clients, and market across the curve and hence have a real impact on our economy FMD DISCUSSION PAPER 17

18. Background How do you promote innovation across markets where each participant is confined to only one part of the market? More importantly, how do you efficiently price across all asset classes in one continuous price curve, intermediating across all markets? We believe we require a major shift in our thinking to allow an institution intermediate the short, medium and long term securities across the entire financial markets. This is the only way the deficient issues mentioned above can be addressed and the market begin to see real growth FMD DISCUSSION PAPER 18

19. The importance of Intermediation • Users of financial intermediation will include governments, large institutions, medium sized corporations, institutions, high net worth individuals; in addition to short, medium and long term investors • Financial intermediation firms will generally advise companies on buying and selling businesses and assist them in managing risks • They will generally work with businesses, local, state and national governments to finance their operations through debt and equity offerings FMD DISCUSSION PAPER 19

20. The importance of Intermediation • They will buy and sell equities, bonds, currencies, commodities primarily to facilitate transactions by their clients in all of the key sectors of the financial markets • They will manage assets for institutions, including mutual funds, pensions and foundations as well as for individuals • They may also invest capital together with their clients in growing businesses which help to create jobs • Finally and importantly, they will create and manage liquidity across the financial markets by acting as dealers / market makers of traded securities FMD DISCUSSION PAPER 20

21. Option 1 – Universal Securities Broker FMD DISCUSSION PAPER 21

22. The case for a Universal Securities Dealer This is defined herein as a firm that is SEC and NSE approved and regulated:- Capital Fixed Income Market Maker – N500m Equities Market Maker – N500m Broker /Dealer – N300m N1,300m This level of capital for our market size MUSTgive access to the wholesale funding market FMD DISCUSSION PAPER 22

23. The case for a Adopting the Malaysian Universal Broker model In Malaysia, the Universal Broker - means a brokerage firm that has merged or acquired at least 3 other brokerage firms (To meet Capital requirements) and has satisfied all conditions and requirements stipulated by the Securities Commission under the Policy frame work for the brokerage industry consolidation Minimum Paid-up capital of RM100m ($31m). Minimum shareholders funds of RM100m ($31m) to be maintained at all times Minimum Capital Adequacy ratio of 1.2x NOTE: these parameters operate in economies c4.5x the size of the Nigerian economy and we can be clever by scaling the requirements to suite our market size – this was previously depicted FMD DISCUSSION PAPER 23

24. The case for a Adopting the Malaysian Universal Broker model • The Universal Broker - Why is this important? • As part of measures to strengthen capacity & competitiveness of universal brokers, brokers that meet the eligibility criteria were allowed to access the interbank market to undertake borrowing or lending • Minimum shareholders funds of RM100m • Strong capital position as measured by capital adequacy ratio (CAR) imposed by the Malaysian bursa (stock exchange) • Satisfactory conduct of current credit facilities obtained from banking institutions • Compliance with prudential and financial regulators imposed by the securities exchange and stock exchange • Limit on aggregate interbank borrowings not to exceed 2x shareholder funds unimpaired by losses FMD DISCUSSION PAPER 24

25. The case for a Adopting the Malaysian Universal Broker model • A robust and effective risk management framework to identidy, measure and monitor risks and • A sound liquidity management framework that encompass strategies to manage funds, ability to match near and short term liquidity requirements and maintain sufficient credit lines, liquefiable assets in managing potential liquidity shortfalls • Universal brokers are allowed to borrow securities from the central bank via repo arrangements to enhance their securities broking activity and will be subject to examination by the central bank and the securities commission where appropriate. FMD DISCUSSION PAPER 25

26. INTERMEDIATION Purchase Securities The case for a Universal Securities Dealer SellSecurities Graphical depiction of how a Universal Broker/Dealer – Market Maker with say N1.5bn in capital (regulated by SEC and CBN) can now provide liquidity due to its ability to fund BUYERS SELLERS Fig 3 FMD DISCUSSION PAPER 26

27. Option 2 – A Financial Dealer Licence FMD DISCUSSION PAPER 27

28. The case for a Financial Market Dealer Licence A Financial Market Dealer (FMD) licence will provide a very essential intermediation function by ensuring that our financial markets across the curve (see fig 2) remain liquid. This will be achieved where such licence and skills give the holder the ability to fund and trade securities across the financial markets from say a 7day note issued under a commercial paper program or medium term note program to permanent capital (equities). FMD DISCUSSION PAPER 28

29. The case for a Financial Market Dealer Licence Going forward, with such a licence, we would expect financial market dealers to provide liquidity and begin to create new products for companies, institutions and governments like interest rate swaps, currency swaps etc. for improved risk management for the institutions and the financial markets FMD DISCUSSION PAPER 29

30. DistributeSecurities OriginateSecurities The case for a Financial Market Dealer Licence TradeSecurities Graphical depiction of how a combined Issuing House and Broker Dealer (regulated by SEC) and a FMD (regulated by CBN) can now perform BORROWERS INVESTORS Fig 3 FMD DISCUSSION PAPER 30

31. The case for a Financial Market Dealer Licence The additional licence should encourage a new paradigm shift to allow for the combined entity to have an evenly spread business model as depicted above. The financial market dealer/Issuing house/Broker/Dealer will therefore be able to function across the entire sphere of the market as shown in fig 2 FMD DISCUSSION PAPER 31

32. Advantages of the proposed model to Regulators Fig 4 Underwriting Financial Advisory Issuing Houses Regulated By SEC Fixed Income PDMM/MM Broker/Dealer FMD Regulated by CBN Fund Portfolio Management Equity/MM1 In – Time Commodity Dealers 1Jointly regulated by SEC/NSE with oversight from the CBN FMD DISCUSSION PAPER 32

33. Advantages of the proposed model to Regulators • Allows for each regulator to still focus on their core areas of competence whilst being able to have an oversight on the other areas of this important financial market intermediary • This leads to greater scrutiny and therefore less probability of systemic risk to the system • Allows for sharing of information, stricter regulation as these firms will be jointly regulated with formalised shared information for all procedures • It also allows for the regulators to grow with these institutions learning from lessons where capital is still relatively small and risks are very manageable. FMD DISCUSSION PAPER 33

34. Advantages to Market • Wider product coverage • Origination, distribution and trading of securities should become seamless • Product development, increased knowledge on pricing across the financial markets leading to deeper liquidity in all markets • Deeper liquidity reduces costs to the end user • Creation of new jobs as sales and trading operations become much bigger, more sophisticated and less risky to manage due to significantly improved information technology infrastructure and risk management systems. FMD DISCUSSION PAPER 34

35. Advantages to Market • The users of financial intermediaries will strongly benefit from lower costs across all markets, efficient pricing, and an ability for firms to now create products for their clients across the entire sphere of the financial markets • To build resilience in the domestic financial markets to withstand shocks by increased participants in the financial intermediation market FMD DISCUSSION PAPER 35

36. What should a Financial Market Dealer Licence holder be allowed to do? Source of funds - • Equity - paid up capital plus reserves • Liabilities • Call Money and short term borrowings • A FMD that is short of funds must be able to: • Obtain from the CBN an overnight advance against acceptable collateral • Sell short term AAA rated assets to the CBN for the CBN to provide rediscounting facilities for treasury and other eligible securities • Enter into repurchase transactions with CBN using eligible securities • Have a CBN account • Access to the interbank market (as discount houses have for alternative short-term funding purposes) FMD DISCUSSION PAPER 36

37. What should a Financial Market Dealer Licence holder be allowed to do? Source of funds - Types of Assets The short to medium term nature of its funding sources and liabilities should require that the assets it funds are generally also short – medium term assets. (Asset/liability matching) The aim of such combined entities is to create and sell down good assets to real money managers – pension funds and other asset managers. FMD DISCUSSION PAPER 37

38. What should a Financial Market Dealer Licence holder be allowed to do? Source of funds - • Therefore the assets it can hold should be as follows:- • Treasury Bills • Treasury Certificates • Negotiable certificates of deposits • Bankers Acceptance • Commercial Paper • Asset Backed Commercial Paper • Asset Backed and Mortgage Backed Securities • Corporate Bonds and Notes • Federal Government Bonds • State and Municipal Bonds • Equities for NOT more than 5 days (Trading Purposes ONLY) • Any other securities that may be from time to time approved by the CBN/SEC/NSE. FMD DISCUSSION PAPER 38

39. Proposed Capital computation Beginning in 2008, many observers remarked that the 2004 change to the United States SEC's net capital rule permitted investment banks to increase their leverage and this played a central role in thefinancial crisis of 2007-2009. This position appears to have been first described by Lee A. Pickard, Director of the SEC's Division of Market Regulation (the former name of the current Division of Trading and Markets) at the time the SEC's uniform net capital rule was adopted in 1975. In an August 8, 2008, commentary, Mr. Pickard wrote that before the 2004 rule change, broker-dealers were limited in the amount of debt they could incur, to a ratio of about 12 times their net capital, but that they operated at significantly lower ratios. FMD DISCUSSION PAPER 39

40. Proposed Capital computation He concluded that, if they had been subject to the net capital rule as it existed before the 2004 rule change, broker-dealers would not have been able to incur their high debt levels without first having increased their capital bases.[10] In what became a widely cited September 18, 2008, New York Sun article (the "2008 NY Sun Article"), Mr. Pickard was quoted as stating the SEC's 2004 rule change was the primary reason large losses were incurred at investment banks. FMD DISCUSSION PAPER 40

41. Proposed Capital computation In late 2008 and early 2009, prominent scholars such as Alan Blinder, John Coffee, Niall Ferguson, and Joseph Stiglitz explained (1) the old net capital rule limited investment bank leverage (defined as the ratio of debt to equity) to 12 (or 15) to 1 and (2) following the 2004 rule change, which relaxed or eliminated this restriction, investment bank leverage increased dramatically to 30 and even 40 to 1 or more. The investment bank leverage cited by these scholars was the leverage reported by the Consolidated Supervised Entity Holding Companies in their financial repoPrts filed with the SEC.[13] FMD DISCUSSION PAPER 41

42. Proposed Capital computation • As noted from the last financial crisis, having excessive capital does not make an institution immune to an insolvency, bankruptcy or liquidity crisis • We therefore advocate for a rather medium level of capital requirement as a head start but with a very strict and much improved monitoring/reporting/regulation on the amount of leverage currently applied by the firm, the assets, tenors, funding, governance structure, market values, asset concentrations etc • Firms should be mandated to have very robust risk management systems and high level risk management personnel. FMD DISCUSSION PAPER 42

43. Proposed Capital computation • We propose that the FMD licence gave a capital of N2.0bn but, with a maximum leverage of 1:15x. • We propose a strict capital / leverage / asset / funding monitoring by both the CBN and SEC FMD DISCUSSION PAPER 43

44. MD CEO: Loss % of capital MD CEO: Number of Days held MD CEO: Maximum Loss per day FMD DISCUSSION PAPER 44

45. Other reasons for a lower capital threshold • Non deposit taking institution • Does not trade currencies • Cannot advance loans as risk assets (illiquidity) • No trade finance business • Purely institutional funding. FMD DISCUSSION PAPER 45

46. Other reasons for a lower capital threshold • Finally, • The financial market dealer licence is intended to serve as a stepping stone for issuing houses, underwriters, broker/dealers, market makers etc to one day become fully fledged Merchant Bank • This also allows for financial inclusion from the institutional level • It also allows for the regulators to grow with these institutions learning from lessons where capital is still relatively small and risks are very manageable. FMD DISCUSSION PAPER 46

47. Option 3 – A Two Tier Merchant Banking License FMD DISCUSSION PAPER 47

48. The case for a creating a two tier merchant bank structure • A two tier structure is proposed as follows: • International Merchant Banking License • Can bid for international issues for the government • Can have operations offshore • National Merchant Banking License • Can only operate within Nigeria • Cannot bid for international issues FMD DISCUSSION PAPER 48

49. Other reasons for a lower capital threshold • Finally, • Financial intermediation remains a very crucial part of the workings of any financial market. Moreso, where the development of infrastructure in the economy is weak and requires a multitude of funding propositions or its middle class requires a viable primary and secondary mortgage markets to function relying on liquid financial markets FMD DISCUSSION PAPER 49

50. Other reasons for a lower capital threshold • Finally, • We believe the case to have new institutions that are jointly regulated by SEC and CBN that can originate, distribute and trade all asset classes across the financial market spectrum is long over-due. • The process for achieving this has little or no hitch to current regulatory practices and will be seen by domestic and foreign observers of the Nigerian financial markets as a major step in the right direction FMD DISCUSSION PAPER 50