Report: 9 Ghanaian Banks Could be Insolvent From Impact of Domestic Debt Exchange

Dr Ernest Addison, Governor of BoG

Accra, Ghana//-If the International Financial Reporting Standard (IFRS) 9 is applied in a stricter sense, nine Ghanaian banks could be insolvent from the impact of the Domestic Debt Exchange Programme (DDEP) on their operations.

However, six banks may not experience any capital losses, while eight banks may experience mild capital losses.

According to a paper by banking consultants, Dr. Richmond Atuahene and K B Frimpong, the impact of a domestic debt exchange on 23 banks’ balance sheets and their ability to provide credit to the economy could be significant as the banks are holding about 37% of government securities.

These losses could be due to a combination of coupon or interest rate reduction, and maturity extension with below-market coupon rates.

“From the data, the capacity of the banking sector to absorb losses is lower not where it is well capitalised to absorb the estimated losses from the debt exchange programme. Ghanaian banks will not be able to absorb losses without having to resort to a recapitalization from the government, or resorting the shareholders and banks for recapitalization quickly to mitigate the risk of bank failure and also protect the stability of the entire banking system and the economy”, it said.

Below is the research

ANALYSING THE DOMESTIC DEBT EXCHANGE PROGRAMME AND FAIR VALUE ACCOUNTING IMPACT ON LOCAL BANKS’ SOLVENCY

(DR RICHMOND A. ATUAHENE AND K.B. FRIMPONG FCCA)

1.0 BACKGROUND

The Ministry of Finance invited on December 5, 2022 holders of 60 old domestic debts to voluntarily exchange ¢137.3 (US$14.3) billion domestic bonds and notes including E.S.L.A and Daakye Bonds, for a package of twelve new eligible domestic bonds.

Under the debt swap or exchange announced on December 5, 2022, local holders including domestic banks, Bank of Ghana, Firms and Institutions, Retail and Individuals, Insurance Companies, Foreign Investors, Rural and Community Banks and SSNIT were to exchange ¢137.3 billion (US$14.3) worth of 60 eligible domestic bonds for 12 new eligible bonds maturing between 2027 to 2038.

Under the initial offer for bondholders with bonds maturing in 2023, the government promised four new bonds that were expected to mature in 2027, 2029, 2032 and 2037 with zero coupon rate in 2023, 5% coupon rate in 2024 and 10% coupon rate in 2025, which would continue till the maturity of last bonds in 2037.

Initially, the Ministry of Finance stated that debt the exchange programme would affect local banks, Bank of Ghana, Firms and Institutions, Foreign Investors, Insurance Companies, Pension Funds, Rural and Community Banks and SSNIT but excluding Retail and Individual Bondholders.

The debt exchange programme was extended to December 30, 2022 because could not achieve the 100% voluntary participation. After fierce resistance from trade unions about the inclusion of pension funds in the domestic debt exchange programme and for the lack of enough voluntary participation, the government announced the extension of the voluntary participation in the programme to January 16, 2023 with following modifications:

  • Offering accrued and unpaid interest on eligible bonds and a cash tender fee payment to holders of eligible bonds maturing in 2023.
  • Increasing the new bonds offered by adding new instruments to the composition of the new bonds for a total of 12 new domestic bonds, one maturing each year starting January 2027 and ending January 2038.
  • Modifying the exchange consideration ratios for each new bond. The exchange consideration ratio applicable to eligible bonds maturing in 2023 will be different other from other eligible bonds.
  • Setting a non-binding target minimum level of overall participation of 80% of the aggregate principal amount outstanding of eligible bonds.
  • Expanding the types of investors that can participate in the exchange to include individual investor.

On January 16, 2023, the government extended the deadline for the domestic debt exchange programme to January 31, 2023, after another resistance by some creditor group particularly individual investors whom the government promised not to include in the programme.

The government made some modifications including:

  • Offering accrued and unpaid interest on eligible bonds and a cash tender fee payment as a carrot to holders of eligible bonds maturing in 2023.
  • (ii) Increasing the new bonds offered by adding eight new bonds to the composition of the new bonds, for a total of 12 new bonds, one maturing each year starting in January, 2027 and ending January 2038. The third extension of deadline for domestic debt exchange programme from  January 31, 2023 to February 7, 2023, for voluntary participation and also as the final deadline for institutions and individuals to sign up to domestic debt exchange programme. The government has made offer which includes the exchange of new bonds with a maximum maturity of five years instead of original 15 years and a 10% coupon rate to individual bondholders below the age of 59 years to encourage them to participate in the domestic debt exchange programme. Additionally, all retirees including those retiring in 2023 will be offered bonds with a maximum maturity of 5 years instead of 15 years and a 15% coupon rate per annum.

Subsequent extensions of dates and payment maturities meant that the remaining stock was reduced from ¢137.3 billion to ¢130 billion. However, the eligible bonds as per memorandum meant an exclusion of pension funds and bonds that were subject to swap mechanisms for monetary and exchange rate policy operations.

This then brought the eligible bonds tendering to ¢97.75 billion. Out of the total eligible bonds for tendering, ¢83 billion ($ 6.7 billion) was successfully tendered-accounting for about 85% of outstanding eligible amounts and meeting the target 80% as expressed in the memorandum of the exchange.

Nevertheless, the ¢87 billion (64%) that were successfully tendered represent only 60% of the original outstanding debt stock of ¢137.3 billion. The strategy employed by the Government of Ghana to achieve full participation for the GDX was aggressive.

Although there was some financial sector consultation on expanding the range of instrument offering prior to crafting the exchange, the debt transaction offer was unilateral with a ‘take‐it‐or‐leave‐it’ approach.

With voluntary participation of only 64% (GH¢87 billion, not underpinned by strong fiscal consolidation, it will not necessary to reverse the adverse fiscal dynamics and reduce the debt overhang that has plagued Ghana for the four years and it will be difficult to achieve Debt to GDP ratio of 55% in 2028.

2. DATA ANALYSIS USING THE NPV OF LOCAL BANKS HOLDING OF GOVERNMENT BONDS AND NOTES.

According to Ministry of Finance (2022), the total government bond and domestic notes value of ¢137.3 billion with the local banks allocated ¢50.6 billion (37%); Firms and Institutions, ¢34.73 billion (25.3%), retail and individuals, ¢22.3 billion (13.9%), Foreign investors, ¢14.83 billion (10.8%); Bank of Ghana, ¢13.73 billion (10%); Rural and Community banks, ¢1.92 billion (1.04%); Insurance companies, ¢1.2 billion (0.09%) and SSNIT ¢55million (0.04%) excluding Pension funds ¢7.69 billion (5.6%) and Treasury bills valued at approximately ¢26.25 billion.

From our data analysis showed that the impact of losses on bank balance sheets had been significant because government securities comprised a large share of bank assets. Any loss in value of government debt exposures had led to capital losses in financial institutions unless these have already been absorbed by provisioning and Mark-to-Market (MTM) accounting which for past years most banks were not applying the MTM.

These recent losses could be due to a combination of coupon or interest rate reduction, and maturity extension with below-market coupon rates of 19.3%. The capacity of the banking sector to absorb losses had been lower, as the banking sector capitalisation only to place three years ago. When banks are able to absorb losses without having to resort to a recapitalisation from the government, the fiscal consolidation and/or burden-sharing by other creditors required to restore debt sustainability would be smaller

From our data analysis using the Net Present Value of the government bondholding of ¢50.6 billion (37%) of the total bonds, then the private sector could face severe challenges in the area of provision of new credit and extension of existing credit as a result of liquidity and solvency crisis in the banking sector.

The impact of a domestic debt exchange on 23 banks’ balance sheets (and their ability to provide credit to the economy) could be significant as the Ghanaian domestic banks are holding about 37% of government securities.

Any loss in value of government debt exposures will lead to regulatory capital impairment in banking institutions at the time of the restructuring unless these have already been absorbed by loan-loss provisioning and mark-to-market accounting which was never applied prior to the restructuring.

Such reduction in the value of government debt portfolio could be due to any changes to the original contractual value of the debt security, such as coupon reduction from 19.3% to a weighted coupon rate of 9%, and maturity extension from 5 years to 15 years.

From the existing discount rate of 19.3 % with 5-year maturity period to the weighted average coupon rate of 9% new bonds with extended maturity period of 15 years, our data analysis showed estimated losses using Net Present Value of ¢41,315,326,692 would impact negatively on 23 banks’ solvency.

For example, Bank B with bond holdings of ¢9,106,452,000, it is estimated that with discount rate of 19.3% using weighted coupon rate of 9% NPV estimated losses resulted in ¢7,435.494,850 from the total shareholders’ equity of ¢2,853,177,000 (December 2021), thus giving the negative net worth of GHC4,452,317,850 making the bank insolvent.

If the IFRS 9 is applied in stricter sense nine banks could be insolvent. From the data analysis only last six banks, R.S.T.U.V and W may not experience any capital losses while eight banks may experience mild capital losses.

These losses could be due to a combination of coupon or interest rate reduction, and maturity extension with below-market coupon rates. From the data, the capacity of the banking sector to absorb losses are lower not where it is well capitalized to absorb the estimated losses from the debt exchange program.

Ghanaian banks will not be able to absorb losses without having to resort to a recapitalisation from the government, or resorting the shareholders and banks for recapitalisation quickly to mitigate the risk of bank failure and also protect the stability of the entire banking system and the economy.

Capital shortfalls are more likely to emerge for a tail of weak banks like A, B, E, D, G, J, K and few others because of their higher share of exposure to government domestic debt relative to their capital.

With the estimated losses using the NPV of banks holding of government bonds, the domestic debt exchange could also have a negative impact on the capital adequacy ratio of banks. The conversion of short-term debt into long-term had increased the risk-weighted assets of the banks which could reduce their capital adequacy ratio. This could lead to decline in the financial stability of local banks and increase the risk of bank failures.

The decline in capital adequacy ratio would lead to a reduction in the overall financial stability of the sector. Though the Bank of Ghana as part of the domestic debt restructuring, announced a regulatory forbearance for banks, it is very important for shareholders and board of directors for banks to take steps to mitigate the negative impact of domestic debt exchange programme exercise on their capital in the balance sheets as their corresponding banks may not recognize the Bank of Ghana’s regulatory forbearance.

TABLE 1

3.0 SOLVENCY GAP FOR 23 BANKS

.

 PVs of Cash Flows
Bank Principal Bond Without DDEP (a) DDEP(b) a-b(Losses)
A              5,255,752,000            23,331,422,187          19,040,056,359          4,291,365,828
B              9,106,452,000            40,425,514,034          32,990,019,184          7,435,494,850
C                 963,270,000              4,276,164,296            3,489,646,218             786,518,078
D              5,832,079,000            25,889,862,645          21,127,920,961          4,761,941,683
E              6,443,840,000            28,605,602,308          23,344,152,610          5,261,449,699
F              1,049,254,000              4,657,865,907            3,801,141,168             856,724,739
G              4,946,815,000            21,959,983,889          17,920,867,727          4,039,116,162
H              1,532,736,737              6,804,150,560            5,552,658,089          1,251,492,471
I                 929,581,040              4,126,611,701            3,367,600,943             759,010,758
J 3,541,278,000            15,720,500,529          12,829,017,180          2,891,483,349
K 2,209,104,000              9,806,691,426            8,002,939,382          1,803,752,045
L 1,213,986,000              5,389,146,956            4,397,917,150             991,229,806
M 1,164,974,000              5,171,572,066            4,220,360,971             951,211,095
N              1,118,825,052              4,966,706,884            4,053,176,795             913,530,090
O 1,912,730,000              8,491,023,008            6,929,262,834          1,561,760,174
P 1,383,955,004              6,143,676,202            5,013,665,271          1,130,010,931
Q 928,690,000              4,122,656,181            3,364,372,965             758,283,216
OTHERS(RSTUVW)              1,066,678,167              4,735,215,560            3,864,263,842             870,951,718
 Total           50,600,000,000          224,624,366,339        183,309,039,647        41,315,326,692

3. THE IMPACT OF DDEP ACCOUNTING LOSSES UNDER IFRS 9 AND MARK TO MARKET VALUATION ON BANKS’ SOLVENCY.

The recent domestic debt exchange programme of unprecedented size and dire consequences is a major concern throughout today’s society, from the popular press to policy-makers, some politicians and academics in the country.

A systemic banking crisis will occur as many as nine local banks in the country are in serious solvency problems at the same time because there are all hit by the domestic debt exchange program estimated losses using the NPV of their holding of government bonds and notes so the near collapse of prestigious banking institutions such as nine  banks will be followed by the near paralysis of the banking sector with its negative consequences for the real economy, makes the past crisis a singular point in the series of modern crises and unquestionably qualifies it as the most severe one since independence of the country’s in 1957.

The uniqueness of the crisis has prompted efforts to identify its determinants and the solutions to cope with it. The crisis is frequently attributed to the bursting of the Ghana’s bond market bubble bust but such a complex event definitely presents a multidimensional profile as well as poor and lax risk management on the part of the banking fraternity.

The recent domestic debt exchange program has led to a major debate about fair-value accounting. Many critics have argued that fair-value accounting, often also called mark-to-market accounting, could significantlycontributed to the banking insolvency or, at least, exacerbated its severity. In this section, we assess these arguments and examine the role of fair-value accounting in the banking insolvency using descriptive data and its empirical evidence.

Based on our data analysis, it is unlikely that fair-value accounting added to the severity of the domestic debt crisis in a major way but it could be due to poor risk management practices within the banking sector as well as regulatory capture and failure.

While there may have been downward spirals or asset-fire sales in bond markets, we find evidence that these effects are the result of fair-value accounting. We also find support for claims that fair-value accounting leads to prudent excessive write-downs of banks’ assets which could impact negatively on banks’ solvency.

If anything, empirical evidence to date points in the opposite direction, that is, towards poor reporting, valuation and classification of government bonds and notes in the previous comprehensive financial position.

Considering the estimated losses using the NPV of 23 local bank holding of government bonds and notes is about of ¢41,315,326,692 which could make nine banks insolvent while the other local banks would experience mild losses on both Capital adequacy ratio (CRD) and Common equity tier 1 (CET 1) ratio. The estimated losses would impact negatively on the statement of financial position and statement of profit or loss and other comprehensive income

In its pure form, fair-value accounting involves reporting assets and liabilities on its pure form, fair-value accounting involves reporting assets and liabilities on the balance sheet at fair value and recognising changes in fair value as on the balance sheet at fair value and recognising changes in fair value as gains and losses in the income statement. When market prices are used to determine fair value, fair-value accounting is also called mark-to-market account-determine fair value.

Some critics argue that fair-value accounting exacerbated the severity of the 2023 of domestic debt restructuring. The most commonly suggested and most plausible mechanism through which fair-value accounting could contribute to a domestic debt exchange program involves the link between accounting and bank capital regulation.

The application of IFRS 9 standard requires the assets or equity interests received or surrendered by the debtor or the creditor are to be measured at fair value. The resulting losses shall be recognized in profit or loss of the local banks.

Under the fair value impairment under IFRS 9 issued and debt restructuring losses were transferred to the capital reserve under the financial position.

The accounting treatment of the valuation changes arising from Ghana debt exchange would be a result of International Financial Report Standard 9 (IFRS 9), the treatment of financial assets is broadly classified as either measured at Fair Value or at Amortised cost. Fair value accounting recognizes a significant portion of the potential loss incurred before Ghana’s debt exchange event materializes.

Where market valuation reflects sovereign debt distress, early recognition of expected losses enhances the loss-absorbing capacity of banks in the event of a debt restructuring as much of the impairment will already be reflected in the banks’ balance sheet. IFRS 9 requires timely recognition of impairment losses on banks’ balance sheet.

Securities held in the “fair value through profit or loss” (FVTPL) portfolio follow mark-to-market (MTM) valuation, and price movements directly affect regulatory capital through the profit and loss statement. For securities held in the “fair value through other comprehensive income” (FVTOCI) portfolio, realized gains or losses are also reflected in bank capital in the same way, but any unrealized gains or losses are accounted for as “other comprehensive income” (OCI).

Although amortised cost securities are not affected by changes in market price any expected credit loss will be accounted in the loan loss reserves. On banking sector outcomes, available indicators appear to suggest that the effects of domestic debt exchange operation overall could be unmanageable considering NPV estimated losses of the 23 banking institutions would impact negatively on regulatory capital.

Under the IFRS 9 or mark-to-market, accounting can cause write-downs and regulatory capital problems for otherwise sound banks. If these banks were to write down its assets to these distorted prices and, as a result, the bank’s regulatory capital could be depleted, the write-distorted prices and, as a result, the banks’ regulatory capital could be depleted.

The Central bank has recently attributed the decline in the industry’s capital adequacy ratio from 19% to 16.6% in December 2022 as the results of losses to mark to market investments, an increase in risk in risk weighted assets and the depreciation of cedi on foreign currency denominated loans but the estimated losses using of the NPV of local banks holdings could be negatively significant.

From the data analysis, we found that the estimated losses using the NPV of banking sector holding of government bonds and other notes could cause the depletion of regulatory capital adequacy ratios, followed critically by liquidity crunch, and decline in banks’ earnings and profitability, customers’ deposits run-down, and deterioration of quality of banks’ risk assets and reduction of banking activities in the area of lending to private sector and SME businesses.

4. Conclusion
Many have called for a suspension or substantial reform of fair-value accounting because it is perceived to have contributed to the severity of the recent domestic debt restructuring. From data analysis, nine banks could be insolvent, while six banks would be solvent and eight banks would experience mild capital losses as a result of domestic debt exchange as well as the application of IFRS 9.

Based on our analysis and the evidence in the literature, we have little reason to believe that fair-value accounting contributed to Ghanaian banks’ problems in the domestic debt crisis in any major way but it was as a result of weak and poor risk management in the banking sector as well as regulatory failure in compliance with the of Banks and Specialized Deposit Taking Act 2016 Act 930 (Section 62 (1) on limit on financial exposures.

Fair values play only a major role for banks’ income statements and regulatory capital ratios, except for a few banks with large trading positions. For these banks, investors would have worried about too much exposures in government bonds and notes, and made their own judgments, even in the absence of fair-value disclosures and weak risk management practices in the banking industry.

In summary, we believe that the claim that fair-value accounting exacerbated the crisis is largely unfounded but it was due to weak and poor in risk management practices in the banking sector as well as regulatory failures on the part of Bank of Ghana. This implies that the case for loosening the existing fair-value accounting rules is weak.

Nevertheless, our conclusions have to be interpreted cautiously and should not be construed as advocating an extension of fair-value accounting, it a call for improvement risk management practices in the banking sector as well as improvement in the regulatory framework

We need more research to understand the effects of fair-value accounting in government bonds and notes to guide efforts to reform the rules. One issue is that fair-value accounting loses many of its desirable properties when prices from active markets are no longer available and hence models have to be used, which in turn makes it very difficult to determine and verify fair values. Thus, it is certainly possible that fair-value accounting rules and the details of their implementation could be further improved.

However, standard setters face many thorny tradeoffs, several of which we discuss in greater detail in Laux and Leuz (2009). First, relaxing the rules or giving management more flexibility to avoid potential problems of fair-value accounting in times of crisis also opens the door for manipulation and can decrease the reliability of the accounting information at a critical time.

One read of the empirical evidence on bank accounting during the domestic debt restructuring is that investors believed that banks used accounting discretion to overstate the value of their assets substantially.

The resulting lack of transparency and poor regulatory oversight about banks’ solvency could be a bigger problem in crises than potential contagion effects from a stricter implementation of fair-value accounting.

Second, even if (stricter) fair-value accounting were to contribute to downward spirals and contagion, these negative effects in times of crisis have to be weighed against the positive effects of timely loss recognition.

When banks are forced to write down the value of assets as losses occur, they have incentives to take prompt corrective action and to limit imprudent lending in the first place, which ultimately reduces the severity of a crisis.

A central lesson of the 2017 -2018 Ghanaian banking crisis is that when regulators hold back from requiring financial institutions to confront their losses, the losses can rapidly become much larger. For the same reason, it is problematic if accounting rules are relaxed or suspended whenever a financial crisis arises because banks can reasonably anticipate such changes, which diminishes their incentives to minimize risks in the first place.

If the goal is to dampen pro-cyclicality, it may be more appropriate to loosen regulatory capital constraints in a crisis than to modify the accounting standards, as the latter could hurt transparency and market discipline

5. RECOMMENDATION

A policy strategy to eliminate shortfalls in bank capital has to be carefully designed to ensure financial stability while limiting fiscal risks, which is particularly difficult during a debt restructuring.

Shortly after the domestic debt restructuring, Bank of Ghana should require viable banks that are likely to need recapitalization to develop a credible plan to restore compliance with capital requirements and buffers over a reasonable period of time, with close supervisory oversight of the implementation of these plans.

In some jurisdiction like Greece, public sector recapitalization or other state support for banks may be considered as a last resort to maintain financial stability and avoid disruption to the real economy, but this may offset part of the debt relief targeted through the domestic debt exchange. If this is the case, additional debt relief may need to be obtained from the sovereign’s other liabilities.

Leveraging a well-designed framework for bank resolution, resolution funding, and deposit insurance could help mitigate risks to financial stability, but contagion risks tend to be higher in debt restructuring cases where credible public sector.

  1. Guarantees and funding backstops may not be
    available.

ii. Bank of Ghana must identify gaps in crisis management and bank resolution frameworks should be identified prior to the domestic debt exchange program. Gaps in early intervention, resolution, deposit insurance, and central bank liquidity assistance for which Bank of Ghana in the process of establishing Financial Stability Support Fund as well as the coordination arrangements among these elements should be addressed before the Domestic Debt Restructuring.

Standard financial safety net components need to be supported by adequate contingency planning for each stage. Where prospects of private sector funding are weak and orderly resolution is unlikely to be feasible, further attention will need to be given to the design of schemes for the potential provision of public solvency support, including the forms of such support, safeguards to minimize moral hazard, and governance arrangements for the management of the public sector’s interest.

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