–Article was first published on 16 April 2020 in the Business Day and has been republished with permission of the author.
- If banks are ‘too big to fail’, then surely manufacturers, hospitals and other critical industries are as well
A recurring critique of commercial regulation is that it is usually enacted ex-post, or after the event. The avalanche of financial regulation that ensued in the aftermath of the Great Recession is a perfect example of this.
Nevertheless, few would argue against the pertinence of landmark legislation such as the Basel III Framework internationally, or the Solvency and Assessment Management Regime in SA. To paraphrase a well-worn Chinese character, the “opportunity” to reform the system after a shock occurs perhaps outweighs the initial danger presented by the shock itself.
The current economic downturn brought about by Covid-19 has already exceeded the turmoil experienced during the Great Recession in unemployment, industrial production and capital market volatility. All this has occurred without fundamentally threatening the now prudently regulated financial system.
This raises the question of why other industries that are clearly too big to fail don’t have their own prudential regulations: perhaps the systemic danger wrought by Covid-19 presents us with the opportunity to legislate a prudential authority for the real economy?
The expression “too big to fail” entered the financial lexicon following the 2008 crisis as a matter of urgency given the precarious situation globally systemic financial institutions found themselves in. Such grand market failures were the result of narrowly defined utility maximisation on the part of management teams and shareholders alike; lazy balance sheets are the enemy of return on equity metrics, after all. Sans a shift in the regulatory environment, the “earnings growth at all cost” attitudes would still persist in the financial sector instead of the more conservative risk budgeting culture.
The mandate of the prudential authority as outlined in its annual report is to “ensure that financial institutions comply with minimum prudential requirements related to capital, liquidity, leverage and other relevant metrics that measure financial health”. This sounds all well and good, no doubt, but how would it work for the real economy?
There is existing precedent for this idea in certain nonfinancial sectors. For example, most countries hold strategic oil reserves. Stockpiling is a prudent safeguard against economic scenarios in which oil supplies are cut off, either for geological, economic or geopolitical reasons. This policy of storing oil for unforeseen scenarios became a matter of urgency in the wake of the Opec price hikes in the 1970s.
Another example would be grain silos: any nation that has suffered through a severe drought will know the importance of food storage. Afgri has storage capacity of five-million tonnes of grain; this amounts to about 40% of SA’s average annual maize production. Storage facilities also exist for minerals: following the five month industry-wide labour strike in 2014, platinum miners built up significant above-ground stocks to counter future production-limiting industrial action.
One can surmise, then, that previous crises in finance, farming and mining have led to mechanisms that prevent significant production shocks from disrupting supply in the short term. How, then, do we extend these mechanisms to the secondary and tertiary sectors of the economy? First, by identifying the sectors within manufacturing and services that are too big to fail (or to be temporarily shut down); second, by designing mechanisms that can be enacted swiftly to safeguard supply chains in these strategic industries; and thirdly, by creating stabilisation measures to support consumption demand.
The first point is a contentious one. A way to formulate the admittedly subjective list might be to distinguish between discretionary and nondiscretionary consumption, and second, to separate domestic demand from export demand. Given our resource constraints, only essential goods and services should be supported.
But what is essential? I’d venture to say water, food, sanitation, household goods, housing, energy, transport, healthcare and education. On the latter concern, export earnings are a crucial source of foreign exchange for the economy as well as a hedge against domestic economic shocks. The list of sectors here should correspond with the national export basket: precious metals, mineral ores, vehicles, machinery, fruit, aluminium, steel and plastics.
Assuming the lists above are sufficient to sustain the economy under periods of duress, we can then consider possible mechanisms to support entities that fall within these sectors. The most obvious would be a form of imitation: capital and liquidity requirements similar to those in the banking sector.
Whereas the CET1 ratio measures asset quality of banks, real economy industries may be more suited to a leverage ratio such as net debt-to-equity. Many firms have debt covenants in place, but these do not apply equally to all firms. In addition, a liquidity measure such as cash interest cover would also be useful. Each industry may have different minimum levels based on the dynamics of the industry, but the supervision and enforcement would apply to all.
These ratios clearly place constraints on return metrics, capital structure and earnings growth. But by establishing capital buffers and liquidity streams, firms would be better able to respond to demand shocks affecting revenues. To deal with supply chain shocks, further mechanisms are required. Another useful tool that can be applied, this time borrowed from the Financial Sector Conduct Authority, is disaster recovery planning. The purpose here is to ensure the continued operation of a firm in the event of a natural disaster such as Covid-19.
Selected firms could rent capacity from nonessential firms operating similar plants that require minimal customisation to produce essential items. This has the added benefit of rental income earned by the nonessential firms that are temporarily shut down while their factories are converted to essential goods production. These rentals could be paid out of the capital buffers built up over the good years, for example.
The final leg of this endeavour is to look at support measures for the demand side of the economy. The primary concern here is ensuring that all firms are able to pay wages during periods of duress. A desirable stress buffer would be, say, three months’ wages at 50% pay — anything more is likely financially unrealistic. Excluding essential industry and government workers, the balance of the employed workforce needs to be covered.
According to the latest quarterly employment data from Stats SA, the total quarterly wage bill in December 2019 was R673bn. Focusing on industries most likely to be furloughed (construction, trade, business services), a sum of about R300bn arises. At 50% of pay, a R150bn fund would be required. Contributions to such a fund could come from the Unemployment Insurance Fund, or an additional levy charged to these industries. Another source of funding could be government “pandemic bonds” issued to local institutional investors.
The measures mentioned hitherto may help prevent future economic pain being meted out to households, entrepreneurs, consumers, landlords, tenants, workers and everyone else in our society. No-one can blame us for failing to foresee the current crisis. Failure to act on it, however, would lie squarely on all our shoulders. The path towards a prudential economy is in some ways a leap into a yet unknown safety net, whose presence on the horizon may, hopefully, signal calmer days ahead.
About the Author
Mashigo is a portfolio manager at Sanlam Private Wealth and a director of CFA SA. He writes in his personal capacity.
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