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Capital requirement, bank competition and stability in Africa- Q&A Session

05.09.2017Jacob Oduor, Principal Research Economist, African Development Bank

This Q&A session highlights key insights of a study co-authored by Dr. Jacob Oduor, economist with African Development Bank. The research shows that increased capital beef-up significantly increases financial instability in Africa (except in big banks) implying that higher capital requirements did not make African banks safer.

1. Why did you choose a topic on the banking sector, precisely on regulation? Is there any subdued risk with African banking system that justifies your research?

The banking sector is important in driving economic growth through intermediation of investment resources. Its effectiveness in achieving this role can however be undermined by one-size-fit-all regulations. In Africa, where financial inclusion is still low, any regulation that increases the cost of financial services may be counterproductive in achieving the broader economic growth objectives. If increased capital requirements can achieve its core objective of financial stability without adversely affecting the cost of financial services, then it is welcome. That tradeoff is important but sometimes difficult to strike.

2. Basel I, Basel II and now Basel III have called for capital build-up over time. In your view, how will the latest reform affect African banks?

Capital build up has the consequence of creating bigger banks. There are two main problems with this. First, emerging evidence show that bigger banks are not necessarily safe. They perceive themselves to be "too big to fail" and therefore engage in more risky investments and are more vulnerable to shocks that smaller banks (Berger and Mester, 1997[1]) and such regulation may just as well increase banking sector instability in Africa. The second and more important consequence for Africa is that capital build-up concentrates the banking industry, reduces competition, has the potential to drive up costs of financial services and stifle financial inclusion. The high initial capital stringency requirements can impose entry barriers for new entrants and this would restrict competition and allow existing banks to accumulate market power (Berger et al; 1993[2]). In a continent where financial inclusion is pathetically low, such regulation may have more negative consequences than benefits.

3. Your research was centered on the impact of regulatory build-up on first financial sector stability and second competition. What did your research reveal?

The results show that increased capital beef-up significantly increases financial instability in Africa (except in big banks) implying that higher capital requirements did not make African banks safer. We also find that increased regulatory capital improves competitive pricing for foreign banks while it makes domestic banks less competitive. This is mainly attributed to the high cost of sourcing and holding extra capital for domestic banks compared to foreign banks who can source cheaper capital from parent companies. The results put to question the effectiveness of higher regulatory capital on stability and competitiveness of the African financial system.

4. Did you find in your literature review similar conclusions?

While other studies including Furlong and Keeley (1989)[3] and Keeley (1990)[4] found stabilizing effects of increased capital requirements, other studies have come to similar conclusions as our study. Boot and Greenbaum (1993)[5] for instance find that capital requirements reduce monitoring incentives, which reduces the quality of banks' portfolios increasing the risk of instability. Hakenes and Schnabel (2010)[6] on the other hand show that tighter capital requirements increases the risk of individual loans and may also increase a bank's probability of default because they relax the competition for loans and thus destabilizing the banking sector.

On increased capital requirements and competition, similar findings as ours were obtained by Bikker & Groeneveld (1998)[7] who assessed competitive structure in the banking industry in the EU and finds that concentration impairs competitiveness. Similar findings were also obtained by and Claessens and Laeven, 2004[8] among others.

5. In your research, you also test your model for reserve causality. What was the idea behind the test and what did the test show?

The potential for reverse causality emanates from the fact that banks that are viewed by the regulators to be less stable are likely to be asked to keep higher capital ratios compared to more stable banks. Instability may therefore be a cause of higher capital requirements for banks as much as higher capital requirements may be a source of instability. The results using instrumental variables approach, confirm the findings that increased capital ratio increases instability in the banking sector.

6. You mentioned that some critics argue that Basel III is too complex and allows banks to use in-house creative models to hold less capital than they should. Can you talk more about some of these techniques and how can regulators address the shortcoming? How will/should this be addressed in the context of the African continent?

Amendments to the Basel Accord in 1996 permitted regulators to accept assessments from banks' internal risk-management models in setting capital requirements for the market risk in banks' trading portfolios. Consequently, trading-book models have become increasingly common in banks. These models generally estimate value at risk (VaR). Because of the large number of traded securities, trading-book VaR models inevitably use a large number of simplifying assumptions resulting in different estimates of value at risk. It is therefore not inconceivable that some banks use these internal models to understate their risks in order to maintain less regulatory capital which exposes the whole sector to risks. To remedy such situation, regulators must ensure banks calculate their risk weightings and capital requirements on the basis of a common standardized approach. In-house models could be used to supplement but not substitute standard models. To reduce the ability of banks to hide risky assets there is need for reduced discretion of banks in calculating their risk weightings by narrowing the range of modeling choices for banks and improving public disclosure by banks. There is also need to explore regulation with varying standards based on complexity and risk.

7. In the US, the concept of "too big to fail" has emerged as a hot contentious topic between regulators, policy makers and banks. A debate between breaking up large banks or at the very least the reinstatement of some Glass-Steagall-like legislation and the status quo. You cite the example of Nigeria as evidence that consolidation is not the answer to the banking system stability. Do you see any systemic risk associated with the size of the banks operating in our continent? Have some of them reached that critical level?

While this study did not go into establishing the specific threshold beyond which inefficiency sets in, experience has shown that big banks can fail and there is a threshold size beyond which decreasing marginal returns sets in. Attempting to build resilience through indefinite increase in capital requirements may be counterproductive. In addition, capital buffers on their own without accompanying regulations are at best, inadequate. Regulation must therefore look beyond the size of the banks. Market concentration in the banking industry in Africa is high compared to the developed world and therefore the potential for systemic risk exists, but whether some African banks have reached that threshold is an area for further research. What is clear from our results is that prescriptive blanket regulations on capital buffers has not helped reduce that risk. Dealing with systemic risk should not therefore overemphasize on size, but accompanying regulations to ensure good governance and prudent risk taking irrespective of the size.

8. If capital build-up is not the answer to increase financial sector stability, what types of policy should regulators and policy makers pursue/explore in their quest for a strong, deep and liquid financial sector?

Capital build up is still important in building resilience, but it is not the only way to build resilience, not in all contexts and on its own it is inadequate. Regulators must be able to identify the sources of systemic risks and develop regulatory instruments that are able to deal with different kinds of risks. Internal governance weaknesses is turning out to be a major source of instability in the banking sector in many countries both in Africa and in more developed markets. This kind of risk cannot be cured by increasing capital buffers. Improvements in monitoring and supervision of banks may as well give the same financial stability outcome without jeopardizing financing inclusion objectives.

9. What is your opinion on the emerging rivalry between fintechs and banks and do you see this as an inevitable event to improve efficiency and increase inclusion? From the regulatory stand-point, what if need be, can be improved?

Without a doubt, fintechs have disrupted the business-as-usual way of traditional banks and helped improve financial access and efficiency beyond the boundaries that traditional banks were willing to go. From mobile money payment and transfer services, to savings and credit services through the mobile phone platforms, fintechs have proved to the banks that your can reach the low-income unbanked and still make profits. Banks are increasingly adopting the same approaches to delivery financial services in order to stay in business. However, in some instances, the pace of adoption of new technologies in the financial sector is faster than regulations. A number of regulators have not developed tools and infrastructure including state of the art reporting and analytics infrastructure to support and sufficiently regulate the fintech innovations. In most cases, fintech companies are discouraged by the time and cost of registering and complying with regulations. This is a particular problematic in the financial services sector in Africa where political interests are still intense and where intruders coming to share the profits are not welcome. In addition, regulations should be flexible and fintech companies should not be forced into the same costly regulatory mold as traditional banks, which may stifle innovative capacity of start-ups.

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[1] Berger, A. N. & L. J. Mester. 1997. Inside the black box: What Explains Differences in The Efficiencies of Financial Institutions? Journal of Banking & Finance, Vol. 21, pp. 895-947

[2] Berger A. N., W. Hunter, and S. Timme. 1993. The Efficiency of Financial Institutions: A Review and Preview of Research Past, Present, and Future, Journal of Banking and Finance, Vol.17 pp. 221-249

[3] Furlong, F. T. and M. C. Keeley. 1989. Capital Regulation and Bank Risk-Taking: A Note, Journal of Banking and Finance 13, 883-891.

[4] Keeley, M. C. 1990. Deposit Insurance, Risk and Market Power in Banking, American Economic Review, Vol. 80(5), pp. 1183-1200

[5] Boot, A.W., and S. Greenbaum. 1993. Bank Regulation, Reputation, and Rents: Theory and Policy Implications. In: Mayer, C., and Vives, X. (eds), Capital Markets andFinancial Intermediation. Cambridge, UK: Cambridge University Press, 292-318.

[6] Hakenes, H. and I. Schnabel. 2010. Capital Regulation, Bank Competition, and Financial Stability, Leibniz University of Hannover, MPI Bonn, and CEPR

[7] Bikker J.A. and J.M. Groeneveld. 1998. Competition and Concentration in the EU Banking Industry Research Series Supervision 8, Netherlands Central Bank, Directorate Supervision

[8] Claessens, Stijn, and Luc Laeven. 2004. What Drives Bank Competition? Some International Evidence. Journal of Money, Credit, and BankingVol. 36, pp. 563-583

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About the Author

Dr. Jacob Oduor is Principal Research Economist at African Development Bank (AfDB). He is a holder of Ph.D in Economics from Bielefeld University, Germany. He is also a holder of MA (Economics) and BA (Economics)- First Class Honours from Kenyatta University, Nairobi, Kenya. Prior to joining AfDB, Dr. Oduor lectured in the School of Economics at Kenyatta University and he worked with the Cooperative Bank of Kenya and the Kenya Institute for Public Policy Research and Analysis (KIPPRA). Dr. Oduor is an accomplished time series econometrician specialized in: time series, cointegration, general macroeconomic theory and policy, monetary policy and growth theory.

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