June 26, 2018//-African central banks that remain stuck in their traditional roles risk being ineffective and becoming out-dated and irrelevant when it comes to managing and regulating the new trends in the global financial ecosystem.
Out of the trending issues, the greening of the financial system, driven by global climatic changes, and how to deal with cryptocurrencies, also known as virtual or digital currencies, are presenting African central banks with major challenges.
On face value, climate change looks alien to central banking. It’s an issue associated with governments that have a primary role in creating green economies and ensuring adherence to international climatic protocols, such as the 2015 Paris Agreement.
Climatic change is however a concern, not only for governments, but for all regulatory arms of governments and ordinary citizens as it impacts on livelihoods, financial systems and economies.
The greening of financial systems is a concept that has recently emerged and is becoming part of the extended mandate for central banks.
Environmental financial risk – the risk arising from climate change – poses significant systemic risks to economies and financial systems which central banks cannot afford to ignore.
According to a Bloomberg opinion piece by Ferdinando Giugliano, ‘Global warming is a Central Bank issue’, “Monetary authorities are right to be mindful of the way in which climate risk affects their mandate to ensure price stability.”
In Africa, we are beginning to see an emerging trend whereby central banks, financial institutions and insurance companies are starting to respond to risks posed by climate change and putting in place financial models and risk management frameworks that take into account environmental risk factors.
As part of managing risks caused by climate change – environmental financial risks – there is an emerging trend wherein financial institutions, as part of their credit rating system, now require more disclosures from customers on their ‘green credentials’, such as in respect of greenhouse gas emissions.
Climate change has made extreme weather events such as heatwaves, severe winters, floods and droughts more frequent. Agriculture is Africa’s largest economic sector, contributing 15% of the continent’s GDP annually, or more than $100bn in 2016.
If farmers fail to produce good harvests due to climatic changes, the financial risks to national financial systems and economies can be devastating.
African countries export agricultural commodities to the global markets in Europe, USA, China and other places, where manufacturing industries depend on them. The effects of climate change not only affect African financial systems and economies, but by extension, global financial systems and economies. When local banks fail to service their obligations due to the effects of climate change, the international financial lenders also take a knock.
Real effects of climate change
The effects of climate change on African economies and financial systems in particular, are more real than hypothetical. African central banks need to manage systemic risks – the risks to entire financial systems – posed by the effects of climate change.
Risk-based bank supervision models and guidelines need to be tweaked to ensure that the financial industry adjusts its financial models, capital adequacy ratios and risk frameworks to deal with climate change related risks.
The debate that has often arisen in credit risk management is: should banks give a lower credit risk weight to ‘green investments and assets’ or ‘green projects’? Should companies which produce renewable energy products or companies that have switched to ‘green systems’ be given lower risk weights when assessing their capital requirements simply because they have gone green? Conversely, should ‘brown assets’ or greenhouse gas emitting investments, be given higher risk weights?
As the world moves towards green economies, in essence this would mean that ‘green assets’ would be cheaper to hold than ‘brown assets’ and that it would be cheaper to invest in green assets than it would in brown assets.
Would it mean, for example, that financing arrangements for combustion-driven machinery or equipment, which burn carbon fossil fuels, would attract higher interest rates than green – solar or lithium battery – powered ones?
If these financial models are adopted in literal terms, greening financial systems could create some socioeconomic challenges, which may be in conflict with established financial lending models. This could produce some backlash for central banks.
“In promoting ‘green investment’, a central bank would risk overstepping its mandate. By choosing to treat bank loans differently depending on their green credentials, a central bank could also be accused of distorting competition in the economy”, concludes Giugliano.
African central banks face challenges in effecting monetary policies that advance greening of financial systems, unlike central banks in the developed world which have already stood up to the challenge of climate change by introducing comprehensive green banking guidelines that cover issues such as carbon pricing, green credit, risk weighting of green and brown assets. However, the new challenges facing African central banks do not end with the greening of financial systems.
Cryptocurrency headaches
The popping up of cryptocurrencies, also known as digital, alternative or virtual currencies, is causing headaches to African central bank governors as their use is increasing, especially with the risk-taking and speculative younger generation.
According to Wikipedia, Bitcoin, created in 2009, was the first cryptocurrency. Bitcoins are created by a process called Bitcoin mining and so far 17m bitcoins have been mined and are in circulation. Other cryptocurrencies have come up, such as Litecoin, Ripple, Dogecoin and Monero.
Cryptocurrency is a virtual medium of exchange that uses cryptography to secure its transactions, create units and verify transfer of assets. Cryptocurrencies do not have a single administrator as they work on a decentralised digital platform that holds or exchanges the virtual currency. Cryptocurrencies offer anonymous transactions by obfuscating the IP address and geo-location of users so that they are untraceable.
Most, if not all, African central banks do not recognise cryptocurrencies as currency, a medium of exchange or legal tender. Algeria’s new finance law of 2018 prohibits trading in virtual currency. Although the global status of cryptocurrencies remains largely undefined, in Western Europe, USA Japan and Dubai, for example, it’s legal to trade in Bitcoin.
On 31 March 2018, the Nigerian Deposit Insurance Corporation (NDIC) clarified that cryptocurrencies are not deposits or financial instruments authorised by the Central Bank of Nigeria: “These forms of currencies are not backed by any physical commodity, such as gold or other precious stones. They do not belong to the category of currencies or coins issued by CBN or the central bank of any country”, according to Adikwu Igoche, Manager in charge of research development at NDIC.
The Kenyan Central Bank, as far back as 2015, issued a public notice warning against use of virtual currencies as no entity in Kenya is currently licensed to offer services using virtual currencies such as Bitcoin, which are not legal tender.
The nature of the virtual currencies has presented African central banks with huge challenges. The scary thing is that, while central banks have no control or monitoring capacity over virtual currencies, virtual currencies have the potential to cause distortions in financial systems and create social problems. Should the platforms that hold or exchange virtual currencies collapse, there is no recourse or protection that governments can offer to their citizens.
The headaches presented to African central banks are that transactions in cryptocurrencies are susceptible to abuse by money launderers, tax evaders, criminals and terrorist organisations. Virtual currencies therefore thwart, to an extent, efforts by central banks in combating illicit financial transactions.
This article was originally published on africanbusinessmagazine.com.
