Caleb M Fundanga: Measures to improve financial regulation and
supervision of the financial system in Zambia
Remarks by Mr Caleb M Fundanga, Governor of the Bank of Zambia, at the United Nations
Working group meeting on the world financial and economic crisis, New York, 3 May 2010.
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The Co-Chairpersons of the Ad hoc Open Ended Working Group on the World
Financial and Economic Crisis
Distinguished Delegates
Ladies and Gentlemen
It is a great honour for me to address this important meeting on the impact and ramifications
of the global financial crisis on economies across the globe. I am particularly encouraged by
the fact that the discussions pay particular focus on the issues of financial sector reform and
how we can best ensure that the financial sector plays its rightful role in facilitating
innovation, enterprise, growth and development.
Chairperson, although the worst effects of the economic recession appear to be behind us,
the negative effects are still being felt, particularly in the advanced economies where
unemployment is likely to remain stubbornly high. According to the most recent forecasts by
the IMF, the global economy is projected to record positive growth of 3.9% in 2010, after
contracting by 0.8% in 2009. However, these growth rates mask significant differences in
economic growth across the world, with emerging and developing countries on the whole
posting much stronger growth rates than the developed or advanced economies. It is obvious
that there will be need to rebalance fiscal and monetary policies in these economies once
growth becomes more broad-based and entrenched to avoid a build up of inflationary
pressures. As the crisis was mainly a result of weak regulatory framework and poor
supervisory oversight in advanced economies, there is also need to continue undertaking
measures to reform the financial systems and enhance global standards for the supervision
of the financial sector.
Zambia weathered the crisis relatively well, with growth in 2009 actually increasing to 6.3%
from 5.7% in 2008. This growth was largely driven by increased output in the mining and
quarrying, construction, agriculture, and energy sectors. Although the Zambia's financial
sector was not directly exposed to toxic assets, the financial crisis and the global recession
that it triggered did impact Zambia's macroeconomic environment. The Zambian economy
suffered reversal of short term capital flows and a slowing down of foreign direct investment,
which had an adverse impact on the exchange rate of the Kwacha against the major
currencies. The collapse in commodity prices as global demand contracted also impacted on
Zambia's mining sector and its related support industries, leading to losses in output and
employment that fed back into the deterioration in the loan book of commercial banks.
Nonperforming loans in the banking sector, for example, rose from around 6% in June 2008 to
12.6% at the end of 2009.
Distinguished delegates, part of the reason for the resilience of Zambia's financial sector
were the comprehensive financial sector reforms that have been systematically undertaken
after the banking sector collapse in the second half of the 1990s. These reforms were
promulgated under a Financial Sector Development Plan (FSDP) that was implemented to
address weaknesses in the financial sector, identified in a Financial Sector Assessment
Programme (FSAP) conducted by the International Monetary Fund (IMF) and the World Bank
in 2002.
Zambia's reforms included the following: the increase in capital requirements for banks;
consolidation of the supervision of bank and non-bank financial institutions under the Bank of
Zambia; legislative reform that gave the Bank of Zambia powers to deal with failing
institutions; and the promulgation of corporate governance guidelines including the conduct
of outreach programmes on good corporate governance practices for the financial sector and
the introduction of credit reference services. The Bank of Zambia is continuing with its work
to improve the financial sector and enhance the role of the financial sector in the
development of the country through the implementation of the second phase of the Financial
sector Development Plan, FSDP II. The FSDP II will focus more narrowly on issues of
competition within the financial sector and extending financial inclusion. However, the fallout
from the crisis has brought to the fore the need to further enhance the regulatory framework
by adopting and fortifying supervisory and regulatory practices which ensure prompt and
effective policy responses to developments in the financial system.
Ladies and Gentlemen, the introduction of credit reference services in Zambia was
necessitated by the poor credit culture, which was identified as one of the weaknesses in the
financial sector, under the FSDP. Bank of Zambia licensed the first ever credit reference
bureau, in 2006, following the introduction of the Credit Reference Services (Licensing)
Guidelines and Credit Data (Privacy Code) 2006. The substantive operations of the CRB
commenced in the fourth quarter of 2008 after a Directive was issued by the Bank of Zambia
on 10 December 2008 mandating all credit providers to use the services of a credit reference
agency before issuing any loan and to provide credit data to a credit reference agency.
However in spite of these efforts, the credit reference system still faces problems, largely
relating to the coverage of sectors, as the current legislation is limited to the financial sector.
In view of this, the Bank of Zambia is currently developing a comprehensive credit reference
law that, amongst other things, will have jurisdiction over all credit providers and data
sources and will provide for the treatment of credit data.
Chairperson, allow me to share with you some of the key regulatory and supervisory issues
that the Bank of Zambia is addressing with regards to the regulation of the financial system in
Zambia and the need to address the supervisory challenges posed by the global financial
crisis. These issues include: the adoption of a risk based supervision (RBS), enhancing the
legislative framework, the determination of capital adequacy, the introduction of a deposit
insurance scheme, the enhancement of our lender of last resort regime, and the
enhancement of cross-border cooperation through consolidated supervision of financial
institutions.
Risk based supervision is a structured, forward-looking process designed to identify key risk
factors to which individual banks are exposed. This approach entails closer interaction with
banks and allows early identification of risks as well as close monitoring of the nature and
direction of risks as they emerge. The banking industry has recorded notable rapid growth in
the last ten years. This growth comes with heightened risk levels. The RBS provides robust
mechanisms to ensure that banks have adequate risk management systems to mitigate
risks. RBS systematically considers all key functional activities (business lines and
operational areas) and, within each key functional area, evaluates the level of risk, quality of
risk management, and direction of risk. The resulting risk profile of the bank, which is
dynamic, will therefore change during the supervisory cycle. This paradigm shift in
supervisory approaches requires a permissive legal and regulatory framework.
In order to ensure timely and credible information for the effective supervision of banks and
other financial institutions, the Bank of Zambia has been playing a key role in developing the
Bank Supervision Application System (BSA), which is a Southern African Development
Community (SADC) region initiative. The BSA is a standardized tool designed for capturing
supervisory information, financial and risk analysis and provides a workflow mechanism for
communicating the different aspects of the supervisory process.
Distinguished delegates, the legal and regulatory framework governing the supervision of
the financial sector must provide for a fast and flexible way of adapting the banking system to
the constantly changing financial landscape. The legal and regulatory frameworks in Zambia
comprise of the Banking and Financial Services Act, Chapter 387 of the Laws of Zambia; the
Bank of Zambia Act, Chapter 360 of the Laws of Zambia; the National Payment Systems Act;
the Prohibition and Prevention of Money Laundering Act; the Bank of Zambia Anti-Money
Laundering Directives; and the Bank of Zambia Corporate Governance Guidelines. The
speed at which changes to these regulatory frameworks can be made is a crucial element of
the reform process in regulatory and supervisory arrangements as it improves policy
responsiveness. A number of challenges exist in this area including the need to update some
of the Statutory Instruments (SIs) in order to reflect the dynamics presently characterizing the
financial markets. In some cases, new guidelines are altogether needed for regulating new
products and innovations such as mobile banking, internet banking and Islamic banking. The
need for quick and appropriate responses to market developments and innovations while
important also need to be balanced by a well designed regulatory framework that ensures
the maintenance of a stable and sound financial system.
Chairperson, the stability and soundness of the financial system is in turn, heavily
dependent on the adequacy of capital. It is essential for the right balance to be struck
between the need for banks to hold adequate capital to absorb losses and the need to
ensure that capital requirements do not unduly constrain from lending to the real economy. It
is also important that banks are not so highly leveraged relative to common equity as to
create incentives for excessive risk taking. The required capital ratios should therefore be
viewed in the context of the high quality capital - Core Tier 1 and Tier II definitions and
should exclude subordinated debt as providing relevant support.
Distinguished delegates, Basel II provides a pragmatic approach to determining overall
capital levels. It introduced a new approach to the definition of relative capital requirements
to be held against specific asset categories. The challenge in this approach is in deciding
what an optimal level of capital is especially in light of massive scale of economic losses now
being suffered as a result of the banking system collapse. However, any theory of optimal
capital level will have to strike a balance between the increased cost of financial
intermediation which result from higher capital requirements and the benefits of the
decreased probability of bank failure and economic harm which will be achieved. Recent
developments have established a prima facie case for higher minimum capital requirements.
The challenge will be for supervisors to manage the transition to higher capital requirements
in a phased approach and take into account the need to avoid procyclical pressure on bank
capital adequacy under conditions of economic downturn. Zambia has adopted Basel II for
implementation although work is still on-going in this area.
The enhanced approaches to capital that I have just described have the potential to
significantly minimize the probability of bank failure. They may also assist in reducing the
extent to which strains on bank capital and liquidity result in an impaired ability to extend
credit to the real economy. But the probability of bank failure cannot be reduced to zero. The
system of bank regulation and supervision therefore needs to be buttressed by arrangements
for deposit insurance (for protecting depositors in the event of default) and for bank
resolution (to ensure orderly wind up and avoid knock-on effects to the rest of the banking
system). In this regard, an effective deposit protection scheme becomes an important aspect
of the financial safety net especially in crisis times. Although Zambia did not experience bank
failures during the current global crisis, work on the establishment of the deposit protection
scheme is currently in progress. Quick bank resolution is also an essential element that
inspires confidence in the financial system. In Zambia, for instance, work on liquidations has
been going on for some time in some cases. The establishment of an effective depositor
protection scheme should assist in early bank resolutions while providing protection to the
most vulnerable depositors.
Chairperson, although the Bank of Zambia has exercised the function of lender of last resort
(LOLR) in the past during the banking crisis in the 1990s, there was no clear LOLR policy
framework in place. There has been renewed concern that the economic slowdown, if
prolonged, could create liquidity pressures in the banking system in Zambia. Past
experiences and current global slowdown build a strong case for a clearly designed LOLR
framework in which the central bank can exercise this function. The challenge in the
regulatory and supervisory arrangements is that of operationalising the lender of last resort.
Lender of last resort should be seen in light of its role in promoting wider public good and
systemic financial stability and ultimately, the wider economic stability. It plays an important
role in the economy to avoid the social cost of a bank failure. Some bank failures may lead to
contagion effect on other banks which has the potential to transmit to the entire economy.
Lender of last resort should be an essential element of the wider institutional framework for
governments and central banks for dealing with banking crises in addition to prompt
corrective action, bank resolution and deposit insurance among others.
Distinguished delegates, the speed with which the crisis spread across the globe highlights
the global nature of financial markets and the importance of cross border supervision. The
risk posed by cross-border operations by financial institutions is clearly significant if not
properly supervised. Over the years, many financial organisations worldwide have adopted
more flexible and complex structures through the establishment of a wide range of
subsidiaries and affiliates that are engaged in business lines different from the core business
of the parent financial institution. The emergence of financial conglomerates has seen
banking activities, asset management or insurance activities that previously were conducted
on a stand-alone basis now being provided within one financial group. Some of these
financial groups operate businesses across borders. The main economic and financial
benefit which encourages the formation of such groups is the enhanced ability to achieve
economies of scale and capture synergies across complementary financial services business
lines. These synergies result in improved operational efficiency and effectiveness due to
lower costs, reduced prices, and improved innovation in products and services. At the same
time, the emergence of such groups has brought complex linkages and relationships among
economic agents. Consequently, they have also necessitated a paradigm shift in supervisory
approaches in order to identify, manage and monitor risks both within and across borders.
Distinguished delegates, previously, supervision of cross-border banks placed significant
reliance on the ultimate home country supervisor to ensure the soundness of the overall
institution. This implied that other regulatory authorities could only provide input to the
supervisory process in the home country. Hence, it was considered appropriate for global
firms to gain the benefits of global approaches to the management of their business and had
significant flexibility in the use of legal entities to book transactions and to manage liquidity
globally. Therefore, the global inter-connectedness made it very difficult for individual
national entities to survive group failure even though they are subsidiaries, given the huge
importance of confidence factors in funding markets. The challenge is how to develop
regulatory and supervisory approaches which will minimize the likelihood of cross-border
failures and to reduce the severity of that impact in the event of a failure materializing. It
would appear that an appropriate response would have to combine both greater coordination
among supervisors and actions aimed at specifically addressing national concerns. On its
part, the Bank of Zambia is currently settling Memoranda of Understanding with various
central banks for effective supervision of entities with cross-border operations. This is also
necessary for enhancing cooperation among the various regulatory authorities in the financial
system in Zambia such as the Pensions and Insurance Authority and the Securities and
Exchange Commission.
Chairperson, in the wake of the financial crisis, there has been renewed interest in
macroprudential supervision. In many countries or economic areas, the institutional
framework for financial stability is being strengthened in the light of the lessons learnt from
the crisis, and incorporates new supervisory tasks and bodies responsible for the
macroprudential regulation of systemic risk and Zambia is no exception. Overall, the current crisis
has revealed that microprudential supervision in many cases proved inadequate to identify,
in a timely manner, the nature and size of accumulating risks and to impose appropriate
remedial action; and that there is therefore, a need to strengthen both the macroprudential
and microprudential supervision of the financial system.
The Bank of Zambia with the help of the World Bank is currently conducting pilot tests of the
World Bank developed Financial Projection Model (FPM) on a number of financial
institutions. Among many other things, the FPM is a tool designed to simulate the effect of
internal and external events upon financial institutions' solvency and profitability to implement
stress scenarios in a dynamic fashion. The Bank of Zambia is also developing a financial
sector contingency plan to address problems of a systemic nature and enhance practical
tools for effectively managing financial distress and potential systemic crisis.
Chairperson, let me conclude by stating that in the wake of the global financial crisis,
Governments around the world and the international community acting together, have an
important opportunity to address some of the structural weaknesses in our domestic
economies and in the global financial system that were laid bare by the crisis. I have already
outlined the broad changes that are being considered. It is, however, important to emphasize
that for the emerging and developing economies, particularly those in SSA, these measures
to reform the international financial architecture need to be carefully considered to ensure
that they build on the strong foundation for economic growth that has been laid over the past
decade.
I thank you for your attention.