Financial Regulation : Has Ghana Reached a Turning Point?

4 February 2019

Ghana has experienced challenges within the banking system in the past but nothing close to what has happened in 2017-19. During this period, nine banks have been liquidated at a cost to the public purse in excess of GHC 9 billion. The ripple effects have been felt throughout the economy and are yet to be fully addressed. The debate continues about the remote and proximate causes of the crisis and regulatory failure is frequently cited as the culprit. In this paper, we discuss the financial regulation architecture in Ghana, how it might have contributed to the bank failures and the options for reform.

Financial regulation is the establishment of specific rules of behavior for financial institutions and the monitoring of compliance through ongoing supervision and surveillance. There are three dimensions of financial regulation: prudential regulation is the regulation of the safety and soundness of the financial institutions; market conduct regulation is the regulation of how financial institutions conduct their business with their customers and the protection of the consumers of financial services; macroprudential regulation relates to the soundness and stability of the financial system as a whole and the management of systemic risk. Economists generally agree that there are economic justifications for financial regulation. The justifications include the correction of market failures and imperfections, the need for consumer protection and confidence and the need maintain systemic stability.

Globally, there is a wide variety of financial regulation architectures of which we can identify the following prototypes:

The traditional model
Fully integrated financial regulation
Partial integration
Twin Peaks regulation

Traditionally the regulatory system has been built by creating regulatory agencies for categories of financial services. In this system, there are separate regulators for insurance, banking, securities and pensions. It is obvious that unless a special effort is made to coordinate the regulatory activities of the agencies, the system has in-built fragmentation. For this reason, it has been called the “silo” system. By far the vast majority of countries operate under this traditional model. In recent times, many silo systems have attempted to improve regulatory coordination by augmenting the regulatory system with Financial Stability Councils whose membership usually includes all the regulatory agencies.

At the opposite end of the continuum, there are regulatory systems that are fully integrated under one supervisor that is either the central bank or an independent agency. In Singapore, the Monetary Authority of Singapore which is the central bank regulates the entire financial system. Until 2013, the

U.K. had the Financial Services Authority, a single regulator outside the central bank. Fully integrated regulatory systems are designed to achieve a high level of regulatory coordination.

Under partial integration, the central bank is usually in charge of banking regulation with all other financial services regulated by a single agency outside the central bank. Until 2018, the Reserve Bank of

South Africa regulated banks while the Financial Services Board regulated all other financial services. Mauritius also operates a similar system. The partial integration model is an attempt to improve regulatory coordination while preserving the primacy of the central bank in banking regulation and financial stability.

Some jurisdictions have opted for unified regulation but with a separation of prudential regulation and market conduct regulation into separate agencies. This latter approach has been established by countries desiring a balance between prudential and market conduct regulation. It has also been observed that prudential supervisors may face a conflict of interest if they also supervise market conduct. This occurs because the prudential supervisor is primarily interested in strengthening the balance sheet of financial institutions and supervisory actions taken in this regard may not be in the interest of the consumer. For these reasons many countries have established independent consumer protection agencies (as in Canada) or a financial ombudsman (as in the U.K.).The model resulting from the separation of prudential regulation and market conduct regulation is called the “Twin Peaks” model. Australia and the United Kingdom are currently operating twin peaks models. South Africa converted to a twin peaks model in 2018.

Many of the regulatory models have emerged from the peculiar circumstances of a country based on country experience, the political system, constitutional provisions and tradition. Since the Global Financial Crisis of 2007-2008, many countries have taken a second look at their regulatory architecture. Many have concluded that the architecture before the crisis did not allow for effective coordination. In addition, the importance of the stability of the financial system and management of systemic risk had not been adequately recognized in pre-crisis regulatory systems. Consequently, there has been a notable increase in the number of countries establishing Financial Stability Councils and moving towards better coordinated regulation.

The financial regulatory system in Ghana is a “silo” system. The BoG regulates banks and special deposit- taking institutions (savings and loan, finance houses, microfinance companies); the Securities and Exchange Commission (SEC) regulates the securities industry and its market operators; the National Insurance Commission (NIC) regulates insurance companies and brokers; the National Pensions Regulatory Authority (NPRA) regulates pensions. The system was not deliberately designed. Indeed, the current regulatory architecture may be considered a historical accident. As each subsector developed a regulatory agency was established to regulate the sector. Relatively little attention was paid to the linkages in the financial sector, thus leaving the regulators to operate relatively independent of each other. However, Ghana ‘s financial system has become much larger with an increasingly wide variety of institutions and financial products and interlinkages between subsectors.

The following developments are instructive:

Regulatory Arbitrage: This occurs when market operators look for loopholes in the system in order to escape regulation. A common type of regulatory arbitrage in Ghana is that because of higher stated capital requirements, promoters find it easier to obtain an SEC licence as a fund manager with a stated capital requirement of GHC100,000 compared to GHC15 million for a Savings and Loan/Finance House licence issued by the BoG. The discrepancy between the licensing and regulatory requirements has led to the phenomenal growth of asset management companies (from 34 in 2007 to 155 in 2017) many of whom operate as disguised deposit takers

(to the chagrin of the SEC), issuing deposit liabilities without the need to comply with the capital, liquidity and solvency rules for formal deposit taking.

Financial Conglomeritization: Today, there are groups of related financial institutions with the same beneficiary ownership with interests in securities, banking, non-bank financial institutions, asset management and insurance. The defunct Beige Group, for example, had interests in insurance, asset management, banking and pension management. Conglomeritization creates a severe asymmetric information gap between the regulator and the conglomerate. Capital can be moved around the related companies undetected by the regulator whose supervision is limited to a subsector such as insurance or securities.
Convergence of financial products: Financial institutions are offering product packages that cut across the traditional boundaries of the sector. The term “bankassurance”, for example has been coined to reflect the sale of insurance products through banks. Another common form of product convergence is the sale of investment products by insurance companies. Investment management is regulated by the SEC while the NIC regulates insurance. By attaching a life insurance rider to the product, an insurance company can escape SEC ‘s supervision of investment advisors and fund managers and remain under NIC regulation which may be inadequate for investment management.
Complexity of financial products: A wide variety of financial products have been added to the product-market space in the last twenty years. The variety of institutions and products in a low financial literacy environment has made the consumer vulnerable to toxic and predatory financial products. At the same time market conduct regulation has not kept up. Ghana has neither a Financial Ombudsman nor an institutionalized framework for consumer protection in financial services
Increased Systemic Risk: Systemic risk is transmitted much more quickly because of the increasing variety of financial institutions and products and technological improvements. For example, banks that are liquidated are likely to have deposit obligations to other banks, specialized deposit taking institutions, fund managers, insurance companies and pension funds. The contagion effects of bank failure have been recently reflected in liquidity challenges for the financial institutions that had placements with the liquidated banks.

The weaknesses of regulatory coordination in Ghana were brought to the fore in the recent brouhaha surrounding MenzGold where there was confusion as to whether the BoG or SEC was the regulator responsible for the licensing and supervision of MenzGold. The weak coordination of financial regulation was noted in Ghana’s Financial Sector Strategic Plan (FINSSP II) in 2012. Recommendation 74 of FINSSP II stated as follows:

Recommendation 74: Establish a Financial Services Board comprising the Heads of Bank of Ghana, National Insurance Commission, the Securities and Exchange Commission and the National Pensions Regulatory Authority and chaired by the Minister of Finance to serve as a forum for coordinating regulatory integration and consistency in the financial sector. MOFEP FSD should provide secretariat support.

Unfortunately, the Recommendation was not implemented. In its place, a Regulator’s Forum was

established but it died because of lack of interest by the top hierarches of the regulatory agencies.

The recently established Financial Stability Council is a significant step towards improving regulatory coordination and improved macroprudential management. The composition of the Council indicates that it will provide a high-level view of the financial system as a whole. However, there is still the need for the regulator to have a full view of the market for the purposes of ongoing supervision and market surveillance. In addition, statutory backing for the Council would enhance its legitimacy and institutionalization.

What would be an improvement on the current silo system beyond the addition of a Financial Stability Council? The single regulator model does not resolve the inherent conflict between prudential regulation and market conduct regulation. Second, the current weakness of market conduct regulation is unlikely to be mitigated under a single regulator which is responsible for both market conduct and prudential regulation. An added complication arises if the single regulator is outside the central bank. In the United Kingdom, it was realized that having a single regulator outside the central bank denied the central bank the critical information needed to act proactively to minimize the impact of the Global Financial Crisis. The partial integration model would also separate the regulation of banking from the regulation of the rest of the financial sector, leaving the system vulnerable to coordination lapses.

For the above reasons, twin peaks regulation appears to be the most transformative in terms of addressing the weaknesses of the current regulatory architecture. We should bear in mind the benefits of the twin peaks model:

The unification of regulation on the basis of functions performed by the regulator. Twin peaks means that the prudential and market conduct regulators can see across the entire sector for purposes of supervision. Regulatory arbitrage and the asymmetric information associated with conglomeritization would be minimized.
A more balanced approach with equal attention given to both prudential regulation and market conduct regulation.

There are variations of the twin peaks models globally. The United Kingdom and South Africa have adopted twin peaks models but have chosen to place the prudential regulation authority under the aegis of the central bank. This is in recognition of the central’s banks overall responsibility for financial soundness and stability. Australia, on the other hand operates a pure twin peaks model with an independent Prudential Regulation Authority. There is of course an extensive conversation to be had before Ghana chooses a new regulatory architecture but there are legal anchors to support the BoG’s primacy in managing overall financial stability and overseeing prudential regulation across the entire financial sector. The first is the constitutional mandate of the BoG “to promote and maintain the stability of the currency of Ghana and direct and regulate the currency system in the interest of the economic progress of Ghana” (Article 183). Section 4 of the Bank of Ghana Act (2002), Act 612 as amended by Act 918, establishes the functions of the BoG as to “promote economic growth and development and effective and efficient operation of the banking and credit system; and contribute to the promotion and maintenance of financial stability in the country”. In addition, Section 3 of the Banks and Specialized Deposit-Taking Institutions Act (2016), Act 930, affirms the role of the BoG as: “ensuring the soundness and stability of the financial system and the protection of depositors in the country through the regulation and supervision of financial institutions”. Collectively, these mandates affirm the primacy of the BoG in maintaining financial stability and signal the placement of prudential regulation under central bank oversight as in the U.K and South Africa. Such an arrangement would also enable the

system as a whole to benefit from the long-established prudential supervisory capacity of the central bank.

What would twin peaks look like in Ghana? Currently there are four regulatory agencies in the financial sector. The BoG regulates banks and special deposit -taking institutions primarily from a prudential regulation perspective. The Bank has some responsibilities for market conduct regulation although the function is not as prominent. The SEC ’s functions cover both prudential and market conduct regulation of the securities industry. However, prudential regulation is relatively limited since the market activities of securities market operators are mostly fee for service activities and are not balance-sheet sensitive. The NIC maintains a balance of prudential and market conduct regulation. Prudential regulation is important for the insurance industry because of the need to ensure that insurance companies are safe and sound to deliver the benefits they have promised, some of which may be decades away. Market conduct is also key because insurance products are backed by complex contracts between insurer and insured. The NPRA is relatively light on prudential regulation since the services provided by its service providers (trustees, fund managers custodians) are not balance sheet sensitive. The current configuration of regulatory institutions suggests that a twin peaks model can be built around the following organizational changes:

A Prudential Regulation Authority is set up under central bank oversight to take responsibility for the prudential regulation of banks, special deposit-taking institutions, securities market operators, insurance companies and pension managers
A Market Conduct Authority is built around the market conduct functions of the BoG, SEC, NPRA, and NIC.
The Financial Stability Council is given statutory backing and strengthened to support the BoG in its macroprudential regulation role.

So far, the case for the unification of financial regulation along the twin functions of prudential and market conduct regulation, has been presented in terms of improved regulatory coordination and improved management of systemic risk. However, there is a strong argument to be made for regulatory unification from a cost reduction perspective. Currently we have four regulatory institutions duplicating the administrative structures needed to carry out regulation of their sectors. The lack of economies of scale makes financial regulation costly for the country as a whole. The cost of regulation can be significantly reduced by concentrating the administrative overhead in the Prudential Regulatory Authority and the Market Conduct Authority instead of the current four regulators that we have.

Is Ghana ready to make such a massive transformation of its financial regulatory architecture? Any major change will require strong leadership by government as it will result in the dismantling of long- established institutions and processes as regulation is consolidated. Established institutions will likely resist changes that will undermine privileged positions. South Africa spent six years discussing and refining ideas on transforming from partial integration to a twin peaks system. By contrast, the U.K.’s transformation from a single regulator to a twin peaks system occurred in less than a year. Ghana may not have the luxury of a six-year debate given our short electoral cycle and the likelihood of major policy swings as administrations change. However, it is time to start a conversation on a purposively designed financial regulatory architecture that can face the future with confidence.