Banking

Advocates of private sector development in Africa are often asked where to begin. To phrase the question another way, is there a way of prioritising reforms to deliver disproportionate benefits upfront and in so doing to accelerate capitalist development? While many areas of economic governance in Africa appear to be crying out for reform — regulation, budgeting, land use, industrial beneficiation and public accountability, to name only a few — donors and academics are increasingly emphasising one area above all others — the financial sector.

The latest IMF Regional Economic Outlook for sub-Saharan Africa, released in May 2006, actually has a chapter dedicated to “building up the financial sector” in the region. While somewhat coy in its assertions, it does conclude with a reform agenda that has far-reaching implications. In particular it appears to imply that there is a case for designing a simpler version of the Basle 2 Protocols for less developed countries.

Basle 2 is of course the new capital adequacy framework for banks, agreed in 2003 and implemented internationally from this year (2006). It has been much criticised for its complexity which, some say, will hinder access to capital for the global poor. All banking supervisory codes tread a fine line between making money available as freely as possible and protecting the overall system against unacceptable risk and potential collapse. Basle 2, the argument goes, errs on the side of prudence.

One critic has argued that while Basel 2 is supposed to “more accurately” align capital requirements to the risks banks face, “it ignores the proven benefits of diversification” — in other words the sheer impact of international loans within less developed economies. This implies that under the Basel 2 regime there will be “an inappropriately large increase in the costs of lending to developing countries” as well a reduction in its volume. The target of this attack is the excessively static International Ratings Based approach at the centre of the Basel 2 protocol. It is basically the assertion that Basel 2 is designed to accommodate risk assessment in the developed world but is insensitive to dynamics in developing countries. The IMF’s 2006 Regional Economic Outlook suggests there are people in that organisation who tend to agree.

The publication argues that “prudential frameworks have been developed for more diversified economies” and that in sub-Saharan Africa, “some prudential rules (such as the ones on debt diversification) are routinely violated, while other, (such as minimum capital levels and zero risk weights for government debt)”, are often set at inappropriate levels. It goes on to suggest that with many countries in sub-Saharan Africa currently “considering” Basel 2 — or perhaps more accurately looking in despair at its complexity (where it hasn’t been simply ignored as being beyond comprehension) — “this may be an opportune time to revise the prudential framework for less industrialised countries.”

What is clear is that most African countries are likely to be extremely slow in implementing Basel 2, if they ever get around to it. A 2004 survey by the Financial Stability Institute, a unit within the Bank for International Settlements (the Basel-based, central banks association) — covering 34 African economies — found a decided tendency to implement the “simpler” provisions of Basel 2 first and move on the “more sophisticated” requirements only after 2009. Although the report argues that between 58 percent and 79 percent of assets in Africa will be covered by Basel 2 by the end of 2006, this is clearly distorted by the preponderance of influence of the South African banking system.

One of the great strengths of the IMF publication is its awareness of the complexity and diversity of the continent. It clearly distinguishes between South Africa, with its sophisticated banking system, comparable with developed countries, a group that it calls “middle income Africa” and the continent’s low income countries. Each group raises a distinctive set of development challenges.

Further subtleties are captured by the IMF’s analysis. Within the category “middle income countries”, a distinction is drawn between oil producers — Angola, Equatorial Guinea and Gabon — which have extremely limited banking systems, focused on lending to government, and the rest (Botswana, Cape Verde, Mauritius, Namibia, Seychelles, South Africa and Swaziland) which have more diversified systems and larger retail networks. Branch densities are on average 10 times higher in the middle-income group. The oil producers, the report observes, face the same challenges as the low income countries.

The IMF report is primarily concerned with the low income less industrialised countries in sub-Saharan Africa. But its comparison between these and the “middle income” countries is instructive. The Fund’s experience is that countries with better functioning financial systems grow faster. Although some observers would say this link is obvious, others have suggested that better financial sectors are simply a reflection of faster growth. The IMF explicitly refutes this suggestion. Forty-four years of data suggests the causal equation is “good financial sector = higher growth” and not the reverse.

These are rather academic debates. But they do have practical implications for reform agendas in sub-Saharan Africa. One thing that is clear from the data is that within the financial sector, it is banks that are overwhelmingly important. These are the dominant institutions on the continent. Insurance, stock markets, non-bank financial intermediaries and microfinance are all tiny by comparison. In fact, outside of the middle-income African countries, banks cover more than 80 percent of the assets in the financial system. This only raises the importance of Basle 2 for poor countries.

The report observes that outside of South Africa, African economies have a higher share of foreign ownership than any other continent. This has increased since 2000 and has, as a result, made many banking systems on the continent more competitive. One of the reasons is that banking in poorer African countries is profitable. This is largely because foreign-owned banks lend almost exclusively to governments and foreign-owned corporates.

Two related factors are worth highlighting. African financial markets are very small which increases overheads and thus raises the cost of banking operations. Banks also tend to be inefficient by international standards thanks mostly to high levels of inflation, corruption and the excessive concentration of the sector. As a result, indigenous African firms pay a great deal for their capital. The IMF notes that “banks can charge high interest margins and remain profitable, a difficult operating environment notwithstanding.”

The IMF suggests that sub-Saharan banking systems can be made more efficient by “eliminating distortions”. The Fund is essentially suggesting the greater internationalisation of African economies through removal of interest rate controls and high reserve requirements. The problem of small market sizes can be addressed through accelerated regionalisation. Monetary unions and harmonisation of regulations — especially within the continent’s various nascent trade blocks — could, it suggests, have a big impact.

The IMF has three further general prescriptions.

First, it suggests that more use should be made of “alternative instruments” to overcome bottlenecks. Property issues will “take some time to address” and the absence of traditional (developed world type) tradeable property rights inhibits loans. The IMF suggests that leasing or “alternatives to collateralisation” — like group guarantees and reversible equity stakes (reminiscent of venture capital) — should be tried, as they have been in other parts of the developing world.

Second, sub-Saharan countries should avoid the temptation to introduce a new range of state-owned financial institutions. Although the IMF publication does not find it necessary to point to recent past experience, many African governments are well aware of how disastrous these sorts of institutions have been. In many cases, they rapidly came under pressure to make political lending decisions and, as a result, ended up holding non-performing portfolios. Add generally lower public sector efficiency standards and the pressure to mop up unemployment and it is not surprising that so many of Africa’s public banks were utterly ineffective. The IMF simply points out that there is a need to “maximise the role of markets, minimise costs and avoid distortions from interventions”.

Third, there is a need for African government to “apply the legal and regulatory framework (more) even-handedly”. This is also a response to the over-politicisation of the financial sectors of a number of African countries. The IMF advocates the establishment of specialised commercial courts and the harmonisation of commercial law and practice within emerging trading regions.

The report points out other more conventional banking problems. In all too many cases, government borrowing has squeezed out the private sector. Like so many of the issues that confront any country attempting to reform its financial sector, proportion is everything. There is nothing wrong with government borrowing per se. In fact holding some low-risk government debt can compensate for high risk elsewhere in a private bank’s portfolio and thus actually facilitate more lending. But this can only happen where banks are able to price their own risk. Interventions such as an artificial floor on deposits or a cap on lending rates limits the potential of private sector banks.

Why should there be any reservations about this development strategy?

The IMF report touches on the issue that is most likely to limit the impact of financial sector reform in less industrialised sub-Saharan countries. It refers to the World Bank’s Doing Business indicators and notes, almost in passing, that Africa’s generally poor legal frameworks — which affect, among other things, property rights and the enforceability of contracts — are key elements limiting the potential impact of financial sector reform. The absence of credit information indices, it observes, is especially problematic. The report states that “there is a strong correlation between private loans as a share of GDP and the (Doing Business) indices for the extent of credit information and the legal rights of creditors.”

Another way of making the same point is to argue that there are close relationships between the strength of the private sector, (non-resources) growth and the effectiveness of the financial systems in sub-Saharan countries. In other words, the problem is not just the financial sector but the entire business environment. It is indeed remarkably difficult for indigenous African enterprises to access capital through the formal financial sector. But this is only one of many problems the business environment throws at them. It is true that it is a problem that can be ameliorated through reforms like those suggested in this IMF publication. But it will be meaningless without the removal of other hurdles in the business environment.

As an experienced African banker points out, “a Ferrari cannot perform (to its potential) on a dirt track.” This does not mean that reforming sub-Saharan banking systems is not urgent. But it does mean that this area, while crucial, is not a magic solution to the problem. That requires comprehensive business environment reforms and the only way to achieve that is incrementally.

This article was first published in Business in Africa Magazine (International Edition), July 2006. To subscribe click here