ENTREPRENEURIAL CHALLENGES – The Case of Royal Bank Zimbabwe Ltd

Industry Shake-up

In December 2003 Mzwimbi went on a well deserved family vacation to the United States, satisfied with the progress and confident that his sprawling empire was on a solid footing. However a call from a business magnate in January 2004 alerted him to what was termed a looming shake- up in the financial services sector. It appears that the incoming governor had confided in a few close colleagues and acquaintances about his plans. This confirmed to Mzwimbi the fears that were arising as RBZ refused to accommodate banks which had liquidity challenges.

The last two months of 2003 saw interest rates soar close to 900% p.a., with the RBZ watching helplessly. The RBZ had the tools and capacity to control these rates but nothing was done to ease the situation. This hiking of interest rates wiped out nearly all the bank’s income made within the year. Bankers normally rely on treasury bills (TBs) since they are easily tradable. Their yield had been good until the interest rates skyrocketed. Consequently bankers were now borrowing at higher interest rates than the treasury bills could cover. Bankers were put in the uncomfortable position of borrowing expensive money and on-lending it cheaply. An example at Royal Bank was an entrepreneur who borrowed $120 million in December 2003, which by March 2004 had ballooned to $500 million due to the excessive rates. Although the cost of funds was now at 900% p.a., Royal Bank had just increased its interest rates to only 400% p.a, meaning that it was funding the client’s shortfall. However this client could not pay it and just returned the $120 million and demonstrated that he had no capacity to pay back the $400 million interest charge. Most bankers accepted this anomaly because they thought it was a temporary dysfunction perpetuated by the inability of an acting governor to make bold decisions. Bankers believed that once a substantive governor was sworn in he would control the interest rates. Much to their dismay, on assuming the governorship Dr. Gono left the rates untamed and hence the situation worsened. This scenario continued up to August 2004, causing considerable strain on entrepreneurial bankers.

On reflection, some bankers feel that the central bank deliberately hiked the interest rates, as this would allow it to restructure the financial services sector. They argue that during the cash crisis of the last half of 2003, bank CEOs would meet often with the RBZ in an effort to find solutions to the crisis. Retrospectively they claim that there is evidence indicating that the current governor though not appointed yet was already in control of the RBZ operations during that time period and was thus responsible for the untenable interest rate regime.

In January 2004, after his vacation, Mzwimbi was informed by the RBZ that Royal had been accommodated for $2 billion on the 28th of December 2003. The Central Bank wanted to know whether this accommodation should be formalised and placed into the newly created Troubled Bank Fund. However, this was expensive money both in terms of the interest rates and also in terms of the conditions and terms of the loan. At Trust Bank, access to this facility had already given the Central Bank the right to force out the top executives, restructure the Board and virtually take over the management of the bank.

Royal Bank turned down the offer and used deposits to pay off the money. However the interest rates did not come down.

During the first quarter of 2004 Trust Bank, Barbican bank and Intermarket Bank were identified as distressed and put under severe corrective orders by the Central Bank.

Royal Assault

Royal Bank remained stable until March 2004. People who had their funds locked up in Intermarket Bank withdrew huge sums of funds from Royal Bank while others were moving to foreign owned banks as the perception created by Central Bank was read by the market to mean that entrepreneurial bankers were fraudsters.

Others withdrew their money on the basis that if financial behemoths like Intermarket can sink, then it could happen to any other indigenously controlled bank. Royal Bank had an advantage that in the smaller towns it was the only bank, so people had no choice. However even in this scenario there were no stable deposits as people kept their funds moving to avoid being caught unawares. For example in one week Royal Bank had withdrawals of over $40 billion but weathered the storm without recourse to Central Bank accommodation.

At this time, newspaper reports indicating some leakage of confidential information started appearing. When confronted, one public paper reporter confided that the information was being supplied to them by the Central Bank. These reports were aimed at causing panic withdrawals and hence exposing banks to depositor flight.

Statutory Reserves

In March 2004, at the point of significant vulnerability, Royal Bank received a letter from RBZ cancelling the exemption from statutory reserve requirements. Statutory reserves are funds, (making up a certain percentage of their total deposits), banks are required to deposit with the Central Bank, at no interest.

When Royal Bank began operations, Mzwimbi applied to the Central Bank – then under Dr Tsumba, for foreign currency to pay for supplies, software and technology infrastructure. No foreign currency could be availed but instead Royal Bank was exempted from paying statutory reserves for one year, thus releasing funds which Royal could use to acquire foreign currency and purchase the needed resources. This was a normal procedure and practice of the Central Bank, which had been made available to other banking institutions as well. This would also enhance the bank’s liquidity position.

Even investors are sometimes offered tax exemptions to encourage and promote investments in any industry. This exemption was delayed due to bungling in the Banking Supervision and Surveillance Department of the RBZ and was thus only implemented a year later, consequently it would run from May 2003 until May 2004. The premature cancellation of this exemption caught Royal Bank by surprise as its cash flow projections had been based on these commencing in May 2004.

When the RBZ insisted, Royal Bank calculated the statutory reserves and noted that, due to a decline in its deposits, it was not eligible for the payment of statutory reserves at that time. When the bank submitted its returns with zero statutory reserves, the Central Bank claimed that the bank was now due for the whole statutory reserve since inception. In effect this was not being treated as a statutory reserve exemption but more as a penalty for evading statutory reserves. Royal Bank appealed. There were conflicting opinions between the Bank Supervision and Capital Markets divisions on the issue as Bank Supervision conceded to the validity of Royal’s position. However Capital Markets insisted that it had instructions from the top to recall the full amount of $23 billion. This was forced onto Royal Bank and transferred without consent to the Troubled Banks Fund at exorbitant rates of 450% p. a.

FML Saga

When FML was demutualising, the executives were concerned about the possibility of being swallowed by its huge strategic partner, Trust Holdings. FML approached Royal Bank and other banks to act as buffers. The agreement was that FML would fund the deal by placing funds with Royal Bank so that Royal would not fund it from its balance sheet.

Consequently FML would leave the deposits with Royal Bank for the tenor of the loan. The deal was consummated through Regal Asset Managers and was to mature in December 2004, at which time it was anticipated that the share price of First Mutual would have blossomed, allowing Royal Bank to harvest its investment and exit profitably. The deal resulted in Regal Asset Managers owning 57 million FML shares. Royal Bank gave FML some securities in the form of treasury bills as collateral for the deposit.

The Reserve Bank and the curator wrote off this investment because at that time FML was suspended at the ZSE. However the fact that it was suspended did not invalidate its value. Recent events have shown that this investment has generated huge capital value for Regal Asset Managers as the ZSE rebounded. Yet the curator valued this investment negatively. Around March 2004 there had been a contagion effect at FML due to the challenges at Trust Bank. This resulted in the forced departure of the FML CEO and chairman. FML was suspended from the local bourse as investigations into the financing structure of Capital Alliance’s acquisition were carried out. Because of the pressure brought to bear on FML, it wanted to withdraw the deposits held by Royal Bank, contrary to the agreement. FML could not locate and return the treasury bills that had been provided as collateral by Royal. Royal Bank suspected that these had been placed with ENG, another asset management company which collapsed in December 2003. A public row broke out. Royal Bank executives sought counsel from Renaissance Merchant Bank, which had brokered the deal, and the Chairman of the ZSE, who both agreed with Royal that the deal was legitimate and FML had to honour the agreement. At this stage FML sought court intervention in an attempt to force Royal Bank into liquidation. Even the curator contested the FML position resulting in his taking it for arbitration. Royal’s position remained that if FML fails to return the securities then it will not get the funds.

Royal bank directors claimed political interference on the issue. The Royal Bank executives believe that the governor, against his better judgment, decided to act against Royal Bank under the pretext of the political pressure. In retrospect, the political support for cracking the whip at Royal gave credence to the rumour that the governor had an underlying agenda in taking Royal and merging it into ZABG because of its strong branch network.

Royal Bank had been warned by friendly RBZ insiders that if it ever accessed the Troubled Bank Fund it would be in trouble, so it sought to avoid this at all costs.

However on 4th August 2004, Royal was served with papers that effectively placed it under the curator. Interestingly, the curator’s contract was signed two days earlier. Until this time no depositor had ever failed to withdraw his deposits from Royal Bank.

The lack of credibility of the Reserve Bank in handling this case is exposed when one considers that some banks were given more than eight months to stabilise under curators, e.g. Intermarket and CFX Banks, and were able to recover. But Royal and Trust Bank were under the curator for less than two months before being amalgamated. The press raised concerns about the curators assuming the role of undertaker rather than nurse, and hence burying these banks.This seemed to confirm the possibility of a hidden agenda on the part of the Central Bank.

Victor Chando

Chando was an excellent financial engineer who set up Victory Financial Services after a stint with MBCA. He had been the brains behind the setting up of the predecessor of Century Discount House which he later sold to Century Holdings. Royal Bank initially had an interest in discount houses and so at inception had included Victor as a significant shareholder. He later acquired Barnfords Securities which Royal intended to bring in-house.

Victory Financial Services was involved in foreign currency dealings, using offshore companies that bought free funds from Zimbabweans abroad and purchased raw materials for Zimbabwean corporations. One such deal with National Foods went sour and the MD reported it to the Central Bank. On investigations the deal was found to be clean but the RBZ went ahead to publish that he was involved in illegal foreign currency transactions and linked this to Royal Bank. However this was a transaction done by a shareholder as an account holder, in which the bank had no interest. What confused matters, was that Victory Financial Services was housed in the same building as Royal Bank.

After failing to nail Chando to any criminal charges, the Central Bank issued an order for Royal Bank to force him out as a shareholder and board member. It is ridiculous that the Central Bank would vet who is a shareholder or not in banks – particularly when the people had no criminal records.

Negotiations with OPEC were underway for it to take over Chando’s shareholding. The Reserve Bank was aware of these developments. OPEC would then help in the recapitalisation as well as open up lines of credit for the bank.

The Arrest

In September 2004 the executive directors of Royal Bank, Mzwimbi and Durajadi, were arrested on five allegations of fraudulently prejudicing the bank. One of the charges was that they fraudulently used depositors’ funds to recapitalise the bank.

Three of the charges after police investigations were dropped, as they were not true. The two remaining charges were:

a) a conflict of interest on loans that were made available to the directors. The RBZ alleges that they did not disclose their interests when companies controlled by them accessed loans at concessionary rates from the bank. However the enterprising bankers dispute these charges, as they claim the Board minutes prove that this interest was disclosed. Even the annual financial statements of the bank acknowledge that they accessed loans as part of their employment contract with the bank.

b) money was owed to Finsreal Asset Management. However Mzwimbi argues that Finsreal actually owes them money and not the other way round. Royal Bank shareholders needed to inject money for recapitalisation of the bank and were requested to deposit their funds with Finsreal Asset Management. Since some had not paid their portion of the recapitalisation by the due date, Royal Financial Holdings, which had an account with Finsreal, paid the money on behalf of the shareholders – who were then indebted to Royal Financial Holdings. Somehow the RBZ confused this transaction as the bank’s funds and therefore accused the

shareholders of using depositors’ funds to recapitalise.

By retrospectively analysing the court case wherein the Royal Bank executive directors are accused of defrauding the bank it appears that the RBZ created a falsehood in order to frustrate the bankers. The curator who initially refused to take a stand before the RBZ appointed Independent Appeal, has in court clearly testified that no monies were stolen from the bank by the directors and that the curator did not (contrary to RBZ assertions) recommend charges against the bankers. In January 2007 the former executive directors of Royal Bank were acquitted by the High Court on the remaining criminal charges after the prosecution failed to present a convincing argument.

Royal Bank assets were sold by the curator to ZABG barely two months after being placed under the curator, without any audited financial statements. The speed at which an agreement of sale was reached is astonishing. The owners of Royal Bank went to court and, after a protracted legal struggle, the court ruled that the assets were sold illegally and hence the sale was “illegal and of no force or effect and therefore null and void”. The court then directed that the owners should appeal to the Central Bank for a determination of the actions of the curators. The Central Bank begrudgingly set up an “independent panel” to adjudicate the case. Strangely ZABG continued to trade on the illegal assets.

The panel advised that the appeal by Royal bank be rejected as it would be difficult to disentangle it from ZABG. They also cited the fact that ZABG had some contractual obligations with third parties who may not want to do business with Royal bank. This strange ruling fails to explain why these considerations were not made when the amalgamation was done. The ruling also redefined the agreements between the curator of Royal bank and ZABG as not being an “agreement of sale” even though the parties which entered into the agreement clearly intended it to be viewed as such. This was a way of circumventing the Supreme Court ruling that the agreement of sale was null and void.

But the panel did not explain how this disposal of the assets should be considered if it was not a sale.

Consequently the major shareholders of Royal appealed to the Minister of Finance who upheld the RBZ decision. Mzwimbi and his colleagues have therefore appealed to the courts. In the meanwhile there was a failed attempt to sell the disputed assets by ZABG despite the outstanding legal challenge. Just ice delayed is justice denied.

Mzwimbi and his team have been denied access to all bank records and yet are expected to defend themselves. As he characteristically puts it, “We are going into this fight blind folded and our hands bound, while fighting someone who has armour and a sword.”

Around 2002-3 there were press reports indicating that the ruling party/state wanted to have a stake in the profitable banking sector. A minister of government at the time of the arrest confirmed this to Mzwimbi and his team. Another bank, NMB, had allegedly been assaulted and the major shareholders were told to dispose of their shareholdings to certain politically connected persons. They refused and had to leave the country after some trumped up charges were preferred against them. Unfortunately, the governor faced resistance and the politicians distanced themselves. One indigenous banker reported how he was summoned to the Central Bank governor’s office and informed that he should leave the country, as his bank would be closed. This banker credits Royal Bank’s resistance to being manipulated as the reason why his own bank survived. The bank was placed under curatorship on 4th August 2004. Mzwimbi had secured potential investors for the recapitalisation of the bank just before the deadline of 30th September 2004. Three days before that deadline, Mzwimbi met the curator and explained in detail the position for the recapitalisation exercise. Investors who had shown interest and were in advanced negotiations were OPEC, Fidelity Insurance and some South African investors. He further asked the curator to request the Central Bank for an extension of about a week. The very next day he was arrested on the pretext that he was about to leave the country. Mzwimbi and his team believe that his arrest at that critical stage was meant to intimidate the would-be investors and result in the failure to recapitalise. This lends credence to the view that the decision to acquire the bank and amalgamate it in ZABG had already been made. The recapitalisation would have scuppered these plans. Notably, other banks were given an extension to regularise their recapitalisation plans.

Shakeman Mugari reported that the central bank has in principle agreed to enter into a scheme of arrangement with Royal, Trust and Barbican banks which could see the final resolution of this issue. He argues that the central bank disregarded the value of securities that the banks had pledged to the central bank for the loans. If these are factored in, then the bank shareholders have some significant value within ZABG. If this scheme had been consummated it would have protected RBZ officials from being sued in their personal capacity for the loss of value to shareholders. From the article it appears like a memorandum of agreement had been signed to effect a reduction of Allied Financial Services’ share in ZABG while the former banks’ shareholders will take up their share in proportion to the value of their assets. This seems to indicate that the central bank has noted a weakness in its arguments.

If this proves true Royal Bank could regain a fairly big stake of ZABG due to its assets which included the real estate and its paper assets which had been undervalued.

The legal hassles show that entrepreneurs in volatile environments face unnecessary political and legal challenges. The rule of law in these countries is sometimes nonexistent. The legislative and political environments, instead of supporting investors, pose serious challenges to entrepreneurs. Entrepreneurs in these environments have to assess the associated risk in setting up their enterprises. However a new breed of entrepreneurs who do not fear the vicissitudes of political interference is making a difference. Entrepreneurs recognise that the environment is a constraint but can be manipulated until worthwhile opportunities are exploited for commercial value. These entrepreneurs choose not to be victims of the environment.
Assault on Entrepreneurs’ Character

The information asymmetry whereby the Central Bank played its case in the public press while the accused bankers had no right of response created a false impression, in the minds of the populace, of entrepreneurs being greedy and unscrupulous.

The Central Bank accused Jeff Mzwimbi and Durajadi Simba of siphoning funds from the bank. An example appeared in a press article in which it was alleged that the sale of Barclays Bank branches to Royal Bank was annulled and the refunded funds were remitted to Mzwimbi and Durajadi at Finsreal Asset Managers and not Royal Bank’s account. This was a clear case of deliberate misinformation as the Central Bank was aware of the truth. Royal Bank had included the purchase of the Bulawayo Barclays Bank branch building which Barclays Bank would lease a portion of from Royal Bank. When Royal Bank fell short at the Interbank Clearing House, it renegotiated with Barclays. This was after Royal was threatened that if it did not clear this amount it would be placed into the Troubled Bank Fund – which carried severe penalties.

The result was that Barclays refunded the amount paying it directly to Royal’s Central Bank account. The RBZ acknowledged receiving these funds. How can they now accuse the founding shareholders of siphoning the same funds which went directly to the RBZ account? Mzwimbi insists that Barclays can easily testify to this.

The RBZ also alleged that Mzwimbi and Durajadi withheld information from their CVs on application for the bank licence and hence questioned their integrity. They claimed that Mzwimbi withheld information on his involvement with a failed bank, UMB. But the business plan for Royal Bank which was filed with RBZ clearly states this involvement. The Central Bank would have these records anyway. They also queried Durajadi’s source of funds and cast aspersions on the net worth statement. Yet Durajadi had been involved in Zimbabwe Trust and a transport business with his brother, which gave him sufficient net worth value.

The RBZ contends that the Board of Royal Bank failed to comply with a directive to recapitalise by 29th July 2004. Royal Bank executives and Board state categorically that they never received this directive. Mzwimbi and his team argue that this is misinformation, as all banks were required to have recapitalised by 30th September 2004.

The regulators also allege that the balance sheet of Royal Bank had a deficit of $140 billion, which the bankers dispute. If one were to consider the disputed $23 billion for statutory reserves and the $20 billion as accommodation from the clearing house, this would amount to $77 billion with interests. However with the undervaluing of the assets and the $160 billion which was written off as uncollectible, there would be no negative balance sheet. The contention of the Royal Executives is that the curator, at the behest of the Reserve Bank, deliberately tampered with the accounts to provide a reason for the take-over. This may be validated by the fact that the curator’s balance sheet kept changing whenever he was challenged and he increased the write-offs, even of funds that had since been collected. Since Royal and Trust Banks were amalgamated into ZABG, the bank is still profitable, without any recapitalisation having been carried out. The very fact that this new amalgamated bank can operate for this long from insolvent banks’ capital without recapitalising lends credence to the argument of the Royal Bank’s owners.

The entrepreneurs contend that they were dealing with a Central Bank which was determined to see them sink and not to protect the integrity of the banking system. This environment was not conducive to survival and it amplified normal weaknesses which could have been resolved in the course of normal business.

Entrepreneurial Determination

Mzwimbi and his colleagues refused to give up under challenging situations. Despite intimidation they took the Central Bank to court and refused to budge until justice was done. They were presented with numerous opportunities to quit the country but would not.

It is reported that they have not given up on their dream. They have set up Royal Financial Services in Kenya, despite the challenges in Zimbabwe. Indeed a sign of perseverance. Press reports indicated that they are in negotiations with Trust Bank so that once they win their case they can merge and continue their operations in Zimbabwe. Trust did not confirm or deny this. The more likely scenario however is that both Trust and Royal could reach a compromise with the central bank resulting in them taking up equity in ZABG subject to an independent revaluation exercise of the assets which were taken over.

Entrepreneurial Principles

The entrepreneurial journey is fraught with risk but can be very rewarding. Some lessons that can be learned from the case study are as follows:

• Entrepreneurs take calculated risk. Mzwimbi did not use all his resources in the bank but left his shareholding in Econet intact. He also sought to diversify his wealth by keeping some investments with FML and Screen Litho. This has been the mainstay of his wealth creation strategy. The disaster that befell the bank did not completely wipe him out because of this prudent investment strategy.

• Entrepreneurs learn from their experiences. Mzwimbi’s vast experiences taught him critical lessons. His international banking experience enabled him to see the emerging trends as Barclays and Standard Chartered withdrew from country towns, creating a route for his entry strategy. His work with Econet taught him perseverance as he and his colleagues fought legal battles with government for the award of the licence. Little did he know that this was just training ground for the battle of his life – the battle for Royal Bank.

• Entrepreneurs need to continuously scan the environment for threats and opportunities. Whereas Mzwimbi and his team were good at noticing the emerging positive trends in the environment at inception, they failed to pick the changes in the regulatory environment when the new governor came on board.

• Entrepreneurial strategy emerges and therefore entrepreneurs should be flexible. Although Royal Bank had a plan to grow at a steady pace, when the opportunity arose to acquire other branches cheaply the entrepreneurs seized the opportunity.

• Entrepreneurs are faced with credibility challenges as customers, regulators and suppliers test the credibility of newcomers. Royal Bank minimised this by recruiting experienced and well known personnel in the market. However the lack of institutional shareholders led to credibility gaps with some corporate clients.

• Entrepreneurs need to craft into their organisations both managerial and leadership competences to ensure both the ability to exploit opportunities (entrepreneurial activity) and sustainable company performance (strategic management). The more contemporary view of entrepreneurship transcends just the venture creation and now encompasses strategic growth. Although Mzwimbi was an excellent leader he needed a strong and powerful manager to consolidate the gains and create solid systems to sustain the rapid growth. Leaders thrive on change while managers thrive on handling complexity and creating order.

• Business is built on relationships as these help in the scanning of the operating environment e.g. critical information about opportunities and threats was obtained from close relationships

Lets close this article with a few questions that an entrepreneur should consider. For instance, if Mzwimbi had expanded less aggressively, would Royal Bank have been safer from the regulators? How could Mzwimbi have protected Royal Bank from political and regulatory interference if he anticipated those risks? If Mzwimbi had selected to pursue his enterprise ideas in a country with a more dependable political and regulatory environment, how would he have performed? Would it have been wiser to keep the equipment, real estate and other assets in Royal Financial Holdings or other corporate entity and only lease them to the bank? In that scenario would the predators have been able to pounce on the bank?

Sources: I Dr Tawafadza A. Makoni confirm being the author of this work. The material for this case study was drawn from my interviews with Mr J Mzwimbi CEO of Royal Bank in February 2006 and two Royal Bank Board Members. Some material was drawn from an unpublished Royal Bank Strategic Business Plan, (2000)

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Overview of Zimbabwean Banking Sector (Part One)

Entrepreneurs build their business within the context of an environment which they sometimes may not be able to control. The robustness of an entrepreneurial venture is tried and tested by the vicissitudes of the environment. Within the environment are forces that may serve as great opportunities or menacing threats to the survival of the entrepreneurial venture. Entrepreneurs need to understand the environment within which they operate so as to exploit emerging opportunities and mitigate against potential threats.

This article serves to create an understanding of the forces at play and their effect on banking entrepreneurs in Zimbabwe. A brief historical overview of banking in Zimbabwe is carried out. The impact of the regulatory and economic environment on the sector is assessed. An analysis of the structure of the banking sector facilitates an appreciation of the underlying forces in the industry.
Historical Background

At independence (1980) Zimbabwe had a sophisticated banking and financial market, with commercial banks mostly foreign owned. The country had a central bank inherited from the Central Bank of Rhodesia and Nyasaland at the winding up of the Federation.

For the first few years of independence, the government of Zimbabwe did not interfere with the banking industry. There was neither nationalisation of foreign banks nor restrictive legislative interference on which sectors to fund or the interest rates to charge, despite the socialistic national ideology. However, the government purchased some shareholding in two banks. It acquired Nedbank’s 62% of Rhobank at a fair price when the bank withdrew from the country. The decision may have been motivated by the desire to stabilise the banking system. The bank was re-branded as Zimbank. The state did not interfere much in the operations of the bank. The State in 1981 also partnered with Bank of Credit and Commerce International (BCCI) as a 49% shareholder in a new commercial bank, Bank of Credit and Commerce Zimbabwe (BCCZ). This was taken over and converted to Commercial Bank of Zimbabwe (CBZ) when BCCI collapsed in 1991 over allegations of unethical business practices.

This should not be viewed as nationalisation but in line with state policy to prevent company closures. The shareholdings in both Zimbank and CBZ were later diluted to below 25% each.
In the first decade, no indigenous bank was licensed and there is no evidence that the government had any financial reform plan. Harvey (n.d., page 6) cites the following as evidence of lack of a coherent financial reform plan in those years:

– In 1981 the government stated that it would encourage rural banking services, but the plan was not implemented.
– In 1982 and 1983 a Money and Finance Commission was proposed but never constituted.
– By 1986 there was no mention of any financial reform agenda in the Five Year National Development Plan.

Harvey argues that the reticence of government to intervene in the financial sector could be explained by the fact that it did not want to jeopardise the interests of the white population, of which banking was an integral part. The country was vulnerable to this sector of the population as it controlled agriculture and manufacturing, which were the mainstay of the economy. The State adopted a conservative approach to indigenisation as it had learnt a lesson from other African countries, whose economies nearly collapsed due to forceful eviction of the white community without first developing a mechanism of skills transfer and capacity building into the black community. The economic cost of inappropriate intervention was deemed to be too high. Another plausible reason for the non- intervention policy was that the State, at independence, inherited a highly controlled economic policy, with tight exchange control mechanisms, from its predecessor. Since control of foreign currency affected control of credit, the government by default, had a strong control of the sector for both economic and political purposes; hence it did not need to interfere.

Financial Reforms

However, after 1987 the government, at the behest of multilateral lenders, embarked on an Economic and Structural Adjustment Programme (ESAP). As part of this programme the Reserve Bank of Zimbabwe (RBZ) started advocating financial reforms through liberalisation and deregulation. It contended that the oligopoly in banking and lack of competition, deprived the sector of choice and quality in service, innovation and efficiency. Consequently, as early as 1994 the RBZ Annual Report indicates the desire for greater competition and efficiency in the banking sector, leading to banking reforms and new legislation that would:

– allow for the conduct of prudential supervision of banks along international best practice
– allow for both off-and on-site bank inspections to increase RBZ’s Banking Supervision function and
– enhance competition, innovation and improve service to the public from banks.

Subsequently the Registrar of Banks in the Ministry of Finance, in liaison with the RBZ, started issuing licences to new players as the financial sector opened up. From the mid-1990s up to December 2003, there was a flurry of entrepreneurial activity in the financial sector as indigenous owned banks were set up. The graph below depicts the trend in the numbers of financial institutions by category, operating since 1994. The trend shows an initial increase in merchant banks and discount houses, followed by decline. The increase in commercial banks was initially slow, gathering momentum around 1999. The decline in merchant banks and discount houses was due to their conversion, mostly into commercial banks.

Source: RBZ Reports

Different entrepreneurs used varied methods to penetrate the financial services sector. Some started advisory services and then upgraded into merchant banks, while others started stockbroking firms, which were elevated into discount houses.

From the beginning of the liberalisation of the financial services up to about 1997 there was a notable absence of locally owned commercial banks. Some of the reasons for this were:

– Conservative licensing policy by the Registrar of Financial Institutions since it was risky to licence indigenous owned commercial banks without an enabling legislature and banking supervision experience.
– Banking entrepreneurs opted for non-banking financial institutions as these were less costly in terms of both initial capital requirements and working capital. For example a merchant bank would require less staff, would not need banking halls, and would have no need to deal in costly small retail deposits, which would reduce overheads and reduce the time to register profits. There was thus a rapid increase in non-banking financial institutions at this time, e.g. by 1995 five of the ten merchant banks had commenced within the previous two years. This became an entry route of choice into commercial banking for some, e.g. Kingdom Bank, NMB Bank and Trust Bank.

It was expected that some foreign banks would also enter the market after the financial reforms but this did not occur, probably due to the restriction of having a minimum 30% local shareholding. The stringent foreign currency controls could also have played a part, as well as the cautious approach adopted by the licensing authorities. Existing foreign banks were not required to shed part of their shareholding although Barclay’s Bank did, through listing on the local stock exchange.

Harvey argues that financial liberalisation assumes that removing direction on lending presupposes that banks would automatically be able to lend on commercial grounds. But he contends that banks may not have this capacity as they are affected by the borrowers’ inability to service loans due to foreign exchange or price control restrictions. Similarly, having positive real interest rates would normally increase bank deposits and increase financial intermediation but this logic falsely assumes that banks will always lend more efficiently. He further argues that licensing new banks does not imply increased competition as it assumes that the new banks will be able to attract competent management and that legislation and bank supervision will be adequate to prevent fraud and thus prevent bank collapse and the resultant financial crisis. Sadly his concerns do not seem to have been addressed within the Zimbabwean financial sector reform, to the detriment of the national economy.

The Operating Environment

Any entrepreneurial activity is constrained or aided by its operating environment. This section analyses the prevailing environment in Zimbabwe that could have an effect on the banking sector.


The political environment in the 1990s was stable but turned volatile after 1998, mainly due to the following factors:

– an unbudgeted pay out to war veterans after they mounted an assault on the State in November 1997. This exerted a heavy strain on the economy, resulting in a run on the dollar. Resultantly the Zimbabwean dollar depreciated by 75% as the market foresaw the consequences of the government’s decision. That day has been recognised as the beginning of severe decline of the country’s economy and has been dubbed “Black Friday”. This depreciation became a catalyst for further inflation. It was followed a month later by violent food riots.
– a poorly planned Agrarian Land Reform launched in 1998, where white commercial farmers were ostensibly evicted and replaced by blacks without due regard to land rights or compensation systems. This resulted in a significant reduction in the productivity of the country, which is mostly dependent on agriculture. The way the land redistribution was handled angered the international community, that alleges it is racially and politically motivated. International donors withdrew support for the programme.
– an ill- advised military incursion, named Operation Sovereign Legitimacy, to defend the Democratic Republic of Congo in 1998, saw the country incur massive costs with no apparent benefit to itself and
– elections which the international community alleged were rigged in 2000,2003 and 2008.

These factors led to international isolation, significantly reducing foreign currency and foreign direct investment flow into the country. Investor confidence was severely eroded. Agriculture and tourism, which traditionally, are huge foreign currency earners crumbled.

For the first post independence decade the Banking Act (1965) was the main legislative framework. Since this was enacted when most commercial banks where foreign owned, there were no directions on prudential lending, insider loans, proportion of shareholder funds that could be lent to one borrower, definition of risk assets, and no provision for bank inspection.

The Banking Act (24:01), which came into effect in September 1999, was the culmination of the RBZ’s desire to liberalise and deregulate the financial services. This Act regulates commercial banks, merchant banks, and discount houses. Entry barriers were removed leading to increased competition. The deregulation also allowed banks some latitude to operate in non-core services. It appears that this latitude was not well delimited and hence presented opportunities for risk taking entrepreneurs. The RBZ advocated this deregulation as a way to de-segment the financial sector as well as improve efficiencies. (RBZ, 2000:4.) These two factors presented opportunities to enterprising indigenous bankers to establish their own businesses in the industry. The Act was further revised and reissued as Chapter 24:20 in August 2000. The increased competition resulted in the introduction of new products and services e.g. e-banking and in-store banking. This entrepreneurial activity resulted in the “deepening and sophistication of the financial sector” (RBZ, 2000:5).

As part of the financial reforms drive, the Reserve Bank Act (22:15) was enacted in September 1999.

Its main purpose was to strengthen the supervisory role of the Bank through:
– setting prudential standards within which banks operate
– conducting both on and off-site surveillance of banks
– enforcing sanctions and where necessary placement under curatorship and
– investigating banking institutions wherever necessary.

This Act still had deficiencies as Dr Tsumba, the then RBZ governor, argued that there was need for the RBZ to be responsible for both licensing and supervision as “the ultimate sanction available to a banking supervisor is the knowledge by the banking sector that the license issued will be cancelled for flagrant violation of operating rules”. However the government seemed to have resisted this until January 2004. It can be argued that this deficiency could have given some bankers the impression that nothing would happen to their licences. Dr Tsumba, in observing the role of the RBZ in holding bank management, directors and shareholders responsible for banks viability, stated that it was neither the role nor intention of the RBZ to “micromanage banks and direct their day to day operations. “

It appears though as if the view of his successor differed significantly from this orthodox view, hence the evidence of micromanaging that has been observed in the sector since December 2003.
In November 2001 the Troubled and Insolvent Banks Policy, which had been drafted over the previous few years, became operational. One of its intended goals was that, “the policy enhances regulatory transparency, accountability and ensures that regulatory responses will be applied in a fair and consistent manner” The prevailing view on the market is that this policy when it was implemented post 2003 is definitely deficient as measured against these ideals. It is contestable how transparent the inclusion and exclusion of vulnerable banks into ZABG was.

A new governor of the RBZ was appointed in December 2003 when the economy was on a free-fall. He made significant changes to the monetary policy, which caused tremors in the banking sector. The RBZ was finally authorised to act as both the licensing and regulatory authority for financial institutions in January 2004. The regulatory environment was reviewed and significant amendments were made to the laws governing the financial sector.

The Troubled Financial Institutions Resolution Act, (2004) was enacted. As a result of the new regulatory environment, a number of financial institutions were distressed. The RBZ placed seven institutions under curatorship while one was closed and another was placed under liquidation.

In January 2005 three of the distressed banks were amalgamated on the authority of the Troubled Financial Institutions Act to form a new institution, Zimbabwe Allied Banking Group (ZABG). These banks allegedly failed to repay funds advanced to them by the RBZ. The affected institutions were Trust Bank, Royal Bank and Barbican Bank. The shareholders appealed and won the appeal against the seizure of their assets with the Supreme Court ruling that ZABG was trading in illegally acquired assets. These bankers appealed to the Minister of Finance and lost their appeal. Subsequently in late 2006 they appealed to the Courts as provided by the law. Finally as at April 2010 the RBZ finally agreed to return the “stolen assets”.

Another measure taken by the new governor was to force management changes in the financial sector, which resulted in most entrepreneurial bank founders being forced out of their own companies under varying pretexts. Some eventually fled the country under threat of arrest. Boards of Directors of banks were restructured.

Economic Environment

Economically, the country was stable up to the mid 1990s, but a downturn started around 1997-1998, mostly due to political decisions taken at that time, as already discussed. Economic policy was driven by political considerations. Consequently, there was a withdrawal of multi- national donors and the country was isolated. At the same time, a drought hit the country in the season 2001-2002, exacerbating the injurious effect of farm evictions on crop production. This reduced production had an adverse impact on banks that funded agriculture. The interruptions in commercial farming and the concomitant reduction in food production resulted in a precarious food security position. In the last twelve years the country has been forced to import maize, further straining the tenuous foreign currency resources of the country.

Another impact of the agrarian reform programme was that most farmers who had borrowed money from banks could not service the loans yet the government, which took over their businesses, refused to assume responsibility for the loans. By concurrently failing to recompense the farmers promptly and fairly, it became impractical for the farmers to service the loans. Banks were thus exposed to these bad loans.

The net result was spiralling inflation, company closures resulting in high unemployment, foreign currency shortages as international sources of funds dried up, and food shortages. The foreign currency shortages led to fuel shortages, which in turn reduced industrial production. Consequently, the Gross Domestic Product (GDP) has been on the decline since 1997. This negative economic environment meant reduced banking activity as industrial activity declined and banking services were driven onto the parallel rather than the formal market.

As depicted in the graph below, inflation spiralled and reached a peak of 630% in January 2003. After a brief reprieve the upward trend continued rising to 1729% by February 2007. Thereafter the country entered a period of hyperinflation unheard of in a peace time period. Inflation stresses banks. Some argue that the rate of inflation rose because the devaluation of the currency had not been accompanied by a reduction in the budget deficit. Hyperinflation causes interest rates to soar while the value of collateral security falls, resulting in asset-liability mismatches. It also increases non-performing loans as more people fail to service their loans.

Effectively, by 2001 most banks had adopted a conservative lending strategy e.g. with total advances for the banking sector being only 21.7% of total industry assets compared to 31.1% in the previous year. Banks resorted to volatile non- interest income. Some began to trade in the parallel foreign currency market, at times colluding with the RBZ.

In the last half of 2003 there was a severe cash shortage. People stopped using banks as intermediaries as they were not sure they would be able to access their cash whenever they needed it. This reduced the deposit base for banks. Due to the short term maturity profile of the deposit base, banks are normally not able to invest significant portions of their funds in longer term assets and thus were highly liquid up to mid-2003. However in 2003, because of the demand by clients to have returns matching inflation, most indigenous banks resorted to speculative investments, which yielded higher returns.

These speculative activities, mostly on non-core banking activities, drove an exponential growth within the financial sector. For example one bank had its asset base grow from Z$200 billion (USD50 million) to Z$800 billion (USD200 million) within one year.

However bankers have argued that what the governor calls speculative non-core business is considered best practice in most advanced banking systems worldwide. They argue that it is not unusual for banks to take equity positions in non-banking institutions they have loaned money to safeguard their investments. Examples were given of banks like Nedbank (RSA) and J P Morgan (USA) which control vast real estate investments in their portfolios. Bankers argue convincingly that these investments are sometimes used to hedge against inflation.

The instruction by the new governor of the RBZ for banks to unwind their positions overnight, and the immediate withdrawal of an overnight accommodation support for banks by the RBZ, stimulated a crisis which led to significant asset-liability mismatches and a liquidity crunch for most banks. The prices of properties and the Zimbabwe Stock Exchange collapsed simultaneously, due to the massive selling by banks that were trying to cover their positions. The loss of value on the equities market meant loss of value of the collateral, which most banks held in lieu of the loans they had advanced.

During this period Zimbabwe remained in a debt crunch as most of its foreign debts were either un-serviced or under-serviced. The consequent worsening of the balance of payments (BOP) put pressure on the foreign exchange reserves and the overvalued currency. Total government domestic debt rose from Z$7.2 billion (1990) to Z$2.8 trillion (2004). This growth in domestic debt emanates from high budgetary deficits and decline in international funding.


Due to the volatile economy after the 1990s, the population became fairly mobile with a significant number of professionals emigrating for economic reasons. The Internet and Satellite television made the world truly a global village. Customers demanded the same level of service excellence they were exposed to globally. This made service quality a differential advantage. There was also a demand for banks to invest heavily in technological systems.

The increasing cost of doing business in a hyperinflationary environment led to high unemployment and a concomitant collapse of real income. As the Zimbabwe Independent (2005:B14) so keenly observed, a direct outcome of hyperinflationary environment is, “that currency substitution is rife, implying that the Zimbabwe dollar is relinquishing its function as a store of value, unit of account and medium of exchange” to more stable foreign currencies.

During this period an affluent indigenous segment of society emerged, which was cash rich but avoided patronising banks. The emerging parallel market for foreign currency and for cash during the cash crisis reinforced this. Effectively, this reduced the customer base for banks while more banks were coming onto the market. There was thus aggressive competition within a dwindling market.

Socio-economic costs associated with hyperinflation include: erosion of purchasing power parity, increased uncertainty in business planning and budgeting, reduced disposable income, speculative activities that divert resources from productive activities, pressure on the domestic exchange rate due to increased import demand and poor returns on savings. During this period, to augment income there was increased cross border trading as well as commodity broking by people who imported from China, Malaysia and Dubai. This effectively meant that imported substitutes for local products intensified competition, adversely affecting local industries.

As more banks entered the market, which had suffered a major brain drain for economic reasons, it stood to reason that many inexperienced bankers were thrown into the deep end. For example the founding directors of ENG Asset Management had less than five years experience in financial services and yet ENG was the fastest growing financial institution by 2003. It has been suggested that its failure in December 2003 was due to youthful zeal, greed and lack of experience. The collapse of ENG affected some financial institutions that were financially exposed to it, as well as eliciting depositor flight leading to the collapse of some indigenous banks.

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Let the Lawsuits Begin – Banks Brace For a Storm of Litigation

In an article in The San Francisco Chronicle in December 2007, attorney Sean Olender suggested that the real reason for the subprime bailout schemes being proposed by the U.S. Treasury Department was not to keep strapped borrowers in their homes so much as to stave off a spate of lawsuits against the banks. The plan then on the table was an interest rate freeze on a limited number of subprime loans. Olender wrote:

“The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value – right now almost 10 times their market worth. The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

“. . . The catastrophic consequences of bond investors forcing originators to buy back loans at face value are beyond the current media discussion. The loans at issue dwarf the capital available at the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail, resulting in massive taxpayer-funded bailouts of Fannie and Freddie, and even FDIC . . . .

“What would be prudent and logical is for the banks that sold this toxic waste to buy it back and for a lot of people to go to prison. If they knew about the fraud, they should have to buy the bonds back.”1

The thought could send a chill through even the most powerful of investment bankers, including Treasury Secretary Henry Paulson himself, who was head of Goldman Sachs during the heyday of toxic subprime paper-writing from 2004 to 2006. Mortgage fraud has not been limited to the representations made to borrowers or on loan documents but is in the design of the banks’ “financial products” themselves. Among other design flaws is that securitized mortgage debt has become so complex that ownership of the underlying security has often been lost in the shuffle; and without a legal owner, there is no one with standing to foreclose. That was the procedural problem prompting Federal District Judge Christopher Boyko to rule in October 2007 that Deutsche Bank did not have standing to foreclose on 14 mortgage loans held in trust for a pool of mortgage-backed securities holders.2 If large numbers of defaulting homeowners were to contest their foreclosures on the ground that the plaintiffs lacked standing to sue, trillions of dollars in mortgage-backed securities (MBS) could be at risk. Irate securities holders might then respond with litigation that could indeed threaten the existence of the banking Goliaths.


MBS investors with the power to bring major lawsuits include state and local governments, which hold substantial portions of their assets in MBS and similar investments. A harbinger of things to come was a complaint filed on February 1, 2008, by the State of Massachusetts against investment bank Merrill Lynch, for fraud and misrepresentation concerning about $14 million worth of subprime securities sold to the city of Springfield. The complaint focused on the sale of “certain esoteric financial instruments known as collateralized debt obligations (CDOs) . . . which were unsuitable for the city and which, within months after the sale, became illiquid and lost almost all of their market value.”3

The previous month, the city of Baltimore sued Wells Fargo Bank for damages from the subprime debacle, alleging that Wells Fargo had intentionally discriminated in selling high-interest mortgages more frequently to blacks than to whites, in violation of federal law.4

Another innovative suit filed in January 2008 was brought by Cleveland Mayor Frank Jackson against 21 major investment banks, for enabling the subprime lending and foreclosure crisis in his city. The suit targeted the investment banks that fed off the mortgage market by buying subprime mortgages from lenders and then “securitizing” them and selling them to investors. City officials said they hoped to recover hundreds of millions of dollars in damages from the banks, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses. The defendants included banking giants Deutsche Bank, Goldman Sachs, Merrill Lynch, Wells Fargo, Bank of America and Citigroup. They were charged with creating a “public nuisance” by irresponsibly buying and selling high-interest home loans, causing widespread defaults that depleted the city’s tax base and left neighborhoods in ruins.

“To me, this is no different than organized crime or drugs,” Jackson told the Cleveland newspaper The Plain Dealer. “It has the same effect as drug activity in neighborhoods. It’s a form of organized crime that happens to be legal in many respects.” He added in a videotaped interview, “This lawsuit said, ‘You’re not going to do this to us anymore.'”5

The Plain Dealer also interviewed Ohio Attorney General Marc Dann, who was considering a state lawsuit against some of the same investment banks. “There’s clearly been a wrong done,” he said, “and the source is Wall Street. I’m glad to have some company on my hunt.”

However, a funny thing happened on the way to the courthouse. Like New York Governor Eliot Spitzer, Attorney General Dann wound up resigning from his post in May 2008 after a sexual harassment investigation in his office.6 Before they were forced to resign, both prosecutors were hot on the tail of the banks, attempting to impose liability for the destructive wave of home foreclosures in their jurisdictions.

But the hits keep on coming. In June 2008, California Attorney General Jerry Brown sued Countrywide Financial Corporation, the nation’s largest mortgage lender, for causing thousands of foreclosures by deceptively marketing risky loans to borrowers. Among other things, the 46-page complaint alleged that:

“‘Defendants viewed borrowers as nothing more than the means for producing more loans, originating loans with little or no regard to borrowers’ long-term ability to afford them and to sustain homeownership’ . . .

“The company routinely . . . ‘turned a blind eye’ to deceptive practices by brokers and its own loan agents despite ‘numerous complaints from borrowers claiming that they did not understand their loan terms.’

“. . . Underwriters who confirmed information on mortgage applications were ‘under intense pressure . . . to process 60 to 70 loans per day, making careful consideration of borrowers’ financial circumstances and the suitability of the loan product for them nearly impossible.’

“‘Countrywide’s high-pressure sales environment and compensation system encouraged serial refinancing of Countrywide loans.'”7

Similar suits against Countrywide and its CEO have been filed by the states of Illinois and Florida. These suits seek not only damages but rescission of the loans, creating a potential nightmare for the banks.


Massive class action lawsuits by defrauded borrowers may also be in the works. In a 2007 ruling in Wisconsin that is now on appeal, U.S. District Judge Lynn Adelman held that Chevy Chase Bank had violated the Truth in Lending Act by hiding the terms of an adjustable rate loan, and that thousands of other Chevy Chase borrowers could join the plaintiffs in a class action on that ground. According to a June 30, 2008 report in Reuters:

“The judge transformed the case from a run-of-the-mill class action to a potential nightmare for the U.S. banking industry by also finding that the borrowers could force the bank to cancel, or rescind, their loans. That decision was stayed pending an appeal to the 7th U.S. Circuit Court of Appeals, which is expected to rule any day.

“The idea of canceling tainted loans to stem a tide of foreclosures has caught hold in other quarters; a lawsuit filed last week by the Illinois attorney general asks a court to rescind or reform Countrywide Financial mortgages originated under ‘unfair or deceptive practices.’

“. . . The mortgage banking industry already faces pressure from state and federal regulators, who have accused banks of lowering underwriting standards and forcing some borrowers, through fraud, into costly adjustable loans that the banks later bundled and sold as high-interest investment vehicles.”

The Truth in Lending Act (TILA) is a 1968 federal law designed to protect consumers against lending fraud by requiring clear disclosure of loan terms and costs. It lets consumers seek rescission or termination of a loan and the return of all interest and fees when a lender is found to be in violation. The beauty of the statute, says California bankruptcy attorney Cathy Moran, is that it provides for strict liability: the aggrieved borrowers don’t have to prove they were personally defrauded or misled, or that they had actual damages. Just the fact that the disclosures were defective gives them the right to rescind and deprives the lenders of interest. In Moran’s small sample, at least half of the loans reviewed contained TILA violations.8 If class actions are found to be available for rescission of loans based on fraud in the disclosure process, the result could be a flood of class suits against banks all over the country.9


Rescission may be a remedy available not only for borrowers but for MBS investors. Many loan sale contracts provide by their terms that lenders must take back loans that default unusually quickly or that contain mistakes or fraud. An avalanche of rescissions could be catastrophic for the banks. Banks were moving loans off their books and selling them to investors in order to allow many more loans to be made than would otherwise have been allowed under banking regulations. The banking rules are complex, but for every dollar of shareholder capital a bank has on its balance sheet, it is supposed to be limited to about $10 in loans. The problem for the banks is that when the process is reversed, the 10 to 1 rule can work the other way: taking a dollar of bad debt back on a bank’s books can reduce its lending ability by a factor of 10. As explained in a BBC News story citing Prof. Nouriel Roubini for authority:

“[S]ecuritisation was key to helping banks avoid the regulators’ 10:1 rule. To make their risky loans appear attractive to buyers, banks used complex financial engineering to repackage them so they looked super-safe and paid returns well above what equivalent super-safe investments offered. Banks even found ways to get loans off their balance sheets without selling them at all. They devised bizarre new financial entities – called Special Investment Vehicles or SIVs – in which loans could be held technically and legally off balance sheet, out of sight, and beyond the scope of regulators’ rules. So, once again, SIVs made room on balance sheets for banks to go on lending.

“Banks had got round regulators’ rules by selling off their risky loans, but because so many of the securitised loans were bought by other banks, the losses were still inside the banking system. Loans held in SIVs were technically off banks’ balance sheets, but when the value of the loans inside SIVs started to collapse, the banks which set them up found that they were still responsible for them. So losses from investments which might have appeared outside the scope of the regulators’ 10:1 rule, suddenly started turning up on bank balance sheets. . . . The problem now facing many of the biggest lenders is that when losses appear on banks’ balance sheets, the regulator’s 10:1 rule comes back into play because losses reduce a banks’ shareholder capital. ‘If you have a $200bn loss, that reduced your capital by $200bn, you have to reduce your lending by 10 times as much,’ [Prof. Roubini] explains. ‘So you could have a reduction of total credit to the economy of two trillion dollars.'”10

You could also have some very bankrupt banks. The total equity of the top 100 U.S. banks stood at $800 billion at the end of the third quarter of 2007. Banking losses are currently expected to rise by as much as $450 billion, enough to wipe out more than half of the banks’ capital bases and leave many of them insolvent.11 If debtors were to deluge the courts with viable defenses to their debts and mortgage-backed securities holders were to challenge their securities, the result could be even worse.


So what would happen if the mega-banks engaging in these irresponsible practices actually went bankrupt? These banks are widely acknowledged to be at fault, but they expect to be bailed out by the Federal Reserve or the taxpayers because they are “too big to fail.” The argument is that if they were allowed to collapse, they would take the economy down with them. That is the fear, but it is not actually true. We do need a ready source of credit, so we need banks; but we don’t need private banks. It is a little-known, well-concealed fact that banks do not lend their own money or even their depositors’ money. They actually create the money they lend; and creating money is properly a public, not a private, function. The Constitution delegates the power to create money to Congress and only to Congress.12 In making loans, banks are merely extending credit; and the proper agency for extending “the full faith and credit of the United States” is the United States itself.

There is more at stake here than just the equitable treatment of injured homeowners and investors in mortgage-backed securities. Banks and investment houses are now squeezing the last drops of blood from the U.S. government’s credit rating, “borrowing” money and unloading worthless paper on the government and the taxpayers. When the dust settles, it will be the banks, investment brokerages and hedge funds for wealthy investors that will be saved. The repossessed will become the dispossessed; and unless your pension fund has invested in politically well-connected hedge funds, you can probably kiss it goodbye, as teachers in Florida already have.

But the banking genie is a creature of the law, and the law can put it back in the bottle. The imminent failure of some very big banks could provide the government with an opportunity to regain control of its finances. More than that, it could provide the funds for tackling otherwise unsolvable problems now threatening to destroy our standard of living and our standing in the world. The only solution that will be more than a temporary fix is to take the power to create money away from private bankers and return it to the people collectively. That is how it should have been all along, and how it was in our early history; but we are so used to banks being private corporations that we have forgotten the public banks of our forebears. The best of the colonial American banking models was developed in Benjamin Franklin’s province of Pennsylvania, where a government-owned bank issued money and lent it to farmers at 5 percent interest. The interest was returned to the government, replacing taxes. During the decades that that system was in operation, the province of Pennsylvania operated without taxes, inflation or debt.

Rather than bailing out bankrupt banks and sending them on their merry way, the Federal Deposit Insurance Corporation (FDIC) needs to take a close look at the banks’ books and put any banks found to be insolvent into receivership. The FDIC (unlike the Federal Reserve) is actually a federal agency, and it has the option of taking a bank’s stock in return for bailing it out, effectively nationalizing it. This is done in Europe with bankrupt banks, and it was done in the United States with Continental Illinois, the country’s fourth largest bank, when it went bankrupt in the 1990s.

A system of truly “national” banks could issue “the full faith and credit of the United States” for public purposes, including funding infrastructure, sustainable energy development and health care.13 Publicly-issued credit could also be used to relieve the subprime crisis. Local governments could use it to buy up mortgages in default, compensating the MBS investors and freeing the real estate for public disposal. The properties could then be rented back to their occupants at reasonable rates, leaving people in their homes without the windfall of acquiring a house without paying for it. A program of lease-purchase might also be instituted. The proceeds would be applied toward repaying the credit advanced to buy the mortgages, balancing the money supply and preventing inflation.


While we are waiting for the federal government to act, there are also private and local possibilities for relieving the subprime crisis. Chris Cook is a British strategic market consultant and the former Compliance Director for the International Petroleum Exchange. He recommends getting all the parties to settle by forming a pool constituted as an LLC (limited liability company), in a partnership framework that brings together occupiers and financiers as co-owners under a neutral custodian. The original owners would pay an affordable rental, and the resulting pool of rentals would be “unitized” (divided into unit interests, similar to a REIT or real estate investment trust). Among other advantages over the usual mortgage-backed security, there would be no loans at interest, since the property would be owned outright by the LLC. Eliminating interest substantially reduces costs. The former owners would be able to occupy the property at an affordable rental, with the option to buy an equity stake in it. For the banks, the advantage would be that they would be able to find investors again, since the risk would have been taken out of the investment by insuring full occupancy at affordable rates; and for the investors, the advantage would be a secure investment with a dependable return.14

Carolyn Betts is an Ohio attorney who served in Washington as issuer’s counsel for MBS trusts formed by various federal governmental entities, and represented Resolution Trust Corporation in its auction of defaulted commercial mortgage loans during the last real estate crisis. She proposes a squeeze play by the states, in the style of that brought against the tobacco companies by a consortium of state attorneys general in the 1990s. She notes that at the end of 2007, at least 20% of the funds held by the Ohio Public Employees’ Retirement System (PERS) were in mortgage backed securities and similar investments. That makes Ohio public money a major investor in these mortgage-related securities. Ohio governments have an interest in not having homes foreclosed upon, since foreclosures destroy local real estate markets, contribute to lower tax revenues and losses on PERS investments, and cause a strain on state and local affordable housing systems. A coordinated series of actions brought by state attorneys general could eliminate the culpable banker middlemen and return the properties to local ownership and control.

Andrew Jackson reportedly told Congress in 1829, “If the American people only understood the rank injustice of our money and banking system, there would be a revolution before morning.” A wave of private actions, class actions and government lawsuits aimed at redressing injurious banking practices could spark a revolution in banking, returning the power to advance “the full faith and credit of the United States” to the United States, and returning community assets to local ownership and control.

1 Sean Olender, “Mortgage Meltdown,” San Francisco Chronicle (December 9, 2007).

2 See Ellen Brown, “The Subprime Trump Card,” webofdebt.com/articles, June 26, 2008.

3 Greg Morcroft, “Massachusetts Charges Merrill with Fraud,” MarketWatch (February 1, 2008).

4 Henry Gomez, Tom Ott, “Cleveland Sues 21 Banks Over Subprime Mess,” The Plain Dealer (Cleveland, January 11, 2008).

5 Ibid.

6 Marc Dann Resigns as Attorney General,” NBC24 (May 14, 2008).

7 E. Scott Reckard, “California Atty. Gen. Jerry Brown Sues Countrywide,” Los Angeles Times (June 26, 2008).

8 Cathy Moran, “And the Truth (in Lending) Shall Set You Free,” mortgagelawnetwork.com (June 11, 2008).

9 Gina Keating, “Mortgage Ruling Could Shock U.S. Banking Industry,” Reuters (June 30, 2008).

10 Michael Robinson, “City of Debt Shows US Housing Woe,” BBC News (December 30, 2007).

11 “Is the Latest Liquidity Crunch in Remission?”, NakedCapitalism(March 26, 2008).

12 See E. Brown, “Dollar Deception: How Banks Secretly Create Money,” webofdebt.com/articles (July 3, 2007).

13 For more on this funding solution and why it would not inflate prices, see E. Brown, “Waking Up on a Minnesota Bridge: How to Solve the Infrastructure Crisis Without Selling Off Our National Assets,” ibid. (August 4, 2007).

14 Chris Cook, “Peak Credit and a Flight to Simplicity,” Asia Times (April 3, 2008).

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Eastern European Banking Model

A traditional banking model in a CEEC (Central and Eastern European Country) consisted of a central bank and several purpose banks, one dealing with individuals’ savings and other banking needs, and another focusing on foreign financial activities, etc. The central bank provided most of the commercial banking needs of enterprises in addition to other functions. During the late 1980s, the CEECs modified this earlier structure by taking all the commercial banking activities of the central bank and transferring them to new commercial banks. In most countries the new banks were set up along industry lines, although in Poland a regional approach has been adopted.

On the whole, these new stale-owned commercial banks controlled the bulk of financial transactions, although a few ‘de novo banks’ were allowed in Hungary and Poland. Simply transferring existing loans from the central bank to the new state-owned commercial banks had its problems, since it involved transferring both ‘good’ and ‘bad’ assets. Moreover, each bank’s portfolio was restricted to the enterprise and industry assigned to them and they were not allowed to deal with other enterprises outside their remit.

As the central banks would always ‘bale out’ troubled state enterprises, these commercial banks cannot play the same role as commercial banks in the West. CEEC commercial banks cannot foreclose on a debt. If a firm did not wish to pay, the state-owned enterprise would, historically, receive further finance to cover its difficulties, it was a very rare occurrence for a bank to bring about the bankruptcy of a firm. In other words, state-owned enterprises were not allowed to go bankrupt, primarily because it would have affected the commercial banks, balance sheets, but more importantly, the rise in unemployment that would follow might have had high political costs.

What was needed was for commercial banks to have their balance sheets ‘cleaned up’, perhaps by the government purchasing their bad loans with long-term bonds. Adopting Western accounting procedures might also benefit the new commercial banks.

This picture of state-controlled commercial banks has begun to change during the mid to late 1990s as the CEECs began to appreciate that the move towards market-based economies required a vibrant commercial banking sector. There are still a number of issues lo be addressed in this sector, however. For example, in the Czech Republic the government has promised to privatize the banking sector beginning in 1998. Currently the banking sector suffers from a number of weaknesses. A number of the smaller hanks appear to be facing difficulties as money market competition picks up, highlighting their tinder-capitalization and the greater amount of higher-risk business in which they are involved. There have also been issues concerning banking sector regulation and the control mechanisms that are available. This has resulted in the government’s proposal for an independent securities commission to regulate capital markets.

The privatization package for the Czech Republic’s four largest banks, which currently control about 60 percent of the sector’s assets, will also allow foreign banks into a highly developed market where their influence has been marginal until now. It is anticipated that each of the four banks will be sold to a single bidder in an attempt to create a regional hub of a foreign bank’s network. One problem with all four banks is that inspection of their balance sheets may throw up problems which could reduce the size of any bid. All four banks have at least 20 percent of their loans as classified, where no interest has been paid for 30 days or more. Banks could make provisions to reduce these loans by collateral held against them, but in some cases the loans exceed the collateral. Moreover, getting an accurate picture of the value of the collateral is difficult since bankruptcy legislation is ineffective. The ability to write off these bad debts was not permitted until 1996, but even if this route is taken then this will eat into the banks’ assets, leaving them very close to the lower limit of 8 percent capital adequacy ratio. In addition, the ‘commercial’ banks have been influenced by the action of the national bank, which in early 1997 caused bond prices to fall, leading to a fall in the commercial banks’ bond portfolios. Thus the banking sector in the Czech Republic still has a long way to go.

In Hungary the privatization of the banking sector is almost complete. However, a state rescue package had to be agreed at the beginning of 1997 for the second-largest state bank, Postabank, owned indirectly by the main social security bodies and the post office, and this indicates the fragility of this sector. Outside of the difficulties experienced with Postabank, the Hungarian banking system has been transformed. The rapid move towards privatization resulted from the problems experienced by the state-owned banks, which the government bad to bail out, costing it around 7 percent of GDP. At that stage it was possible that the banking system could collapse and government funding, although saving the banks, did not solve the problems of corporate governance or moral hazard. Thus the privatization process was started in earnest. Magyar Kulkereskedelmi Bank (MKB) was sold to Bayerische Landesbank and the EBDR in 1994, Budapest Bank was bought by GE Capital and Magyar Hitel Bank was bought by ABN-AMRO. In November 1997 the state completed the last stage of the sale of the state savings bank (OTP), Hungary’s largest bank. The state, which dominated the banking system three years ago, now only retains a majority stake in two specialist banks, the Hungarian Development Bank and Eximbank.

The move towards, and success of privatization can be seen in the balance sheets of the banks, which showed an increase in post-tax profits of 45 percent in 1996. These banks are also seeing higher savings and deposits and a strong rise in demand for corporate and retail lending. In addition, the growth in competition in the banking sector has led to a narrowing of the spreads between lending and deposit rates, and the further knock-on effect of mergers and small-hank closures. Over 50 percent of Hungarian bank assets are controlled by foreign-owned banks, and this has led to Hungarian banks offering services similar to those expected in many Western European countries. Most of the foreign-owned but mainly Hungarian-managed banks were recapitalized after their acquisition and they have spent heavily on staff training and new information technology systems. From 1998, foreign banks will be free to open branches in Hungary, thus opening up the domestic banking market to full competition.

As a whole, the CEECs have come a long way since the early 1990s in dealing with their banking problems. For some countries the process of privatization still has a long way to go but others such as Hungary have moved quickly along the process of transforming their banking systems in readiness for their entry into the EU.

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