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Early Warning Systems and Banking Crises in Low Income Countries in Sub-Saharan Africa

20.05.2013Pietro Calice

The global financial crisis has stimulated renewed interest among academics and policymakers in early warning systems (EWSs) or models able to provide risk alerts on the potential for systemic banking crises on an objective and systematic basis. Most of the attention has been devoted to advanced economies, which have been at the epicentre of the recent turmoil. With the notable exception of the IMF, which has recently initiated a research program aimed at enhancing its financial sector surveillance framework, low income countries (LICs), particularly in Sub-Saharan Africa (SSA), have not been explored as of late.  

SSA LICs’ banking systems have on average proved resilient to the recent episodes of global financial stress. This is primarily the result of the structural reforms implemented by many countries over the past decade within a context of sound macroeconomic policies. Most countries have improved the regulatory framework for supervision, bolstering prudential requirements and supervisory rules. However, as banking systems deepen and new sources of risks materialise SSA LICs need to move ahead with their plans to strengthen supervisory capacity and financials sector resilience. Further actions are warranted to explore the impact of macroeconomic and financial developments on systemic banking risk. In this respect, EWSs can represent a valuable tool for policymakers and regulators in the region.  

In a forthcoming paper co-authored with Giovanni Caggiano (University of Padua) and Leone Leonida (Queen Mary University of London) we develop an EWS of new generation to predict systemic banking crises in SSA LICs. In particular, we focus on a sample of 38 countries during 1980-2008. Focusing on a group of homogenous economies contributes to improve the predictive power of EWSs. Moreover, despite having experienced a number of systemic distress episodes, especially during the 80s and 90s, SSA LICs have received no attention in the relevant empirical literature. We test for a number of macroeconomic and financial variables that have been widely used in the literature as well as for indicators proxying the structural characteristics of SSA LICs’ banking systems.  

We find that a decline in real output, a depreciation of the nominal exchange rate, high domestic credit growth, and banking system illiquidity are all positively correlated with the probability of incurring a systemic banking crisis in SSA LICs. Our findings indicate that banking distress in SSA LICs is typically preceded by weakening macroeconomic fundamentals, in particular a slowdown in economic activity and a depreciation of the currency. Given the low economic diversification of SSA LICs, any decline in GDP growth is felt by the banking sector through a generalised deterioration in asset quality, which increases the probability of a systemic banking crisis, other things being equal.  

On the other hand, a depreciation of the exchange rate lends credence to the hypothesis that banking crises in SSA LICs may be driven by excessive foreign exchange (FX) risk exposure. Our results show that currency turmoil can indeed trigger a banking crisis when banks are highly exposed to FX risk. This can affect the banking system directly, through currency mismatches in the balance sheet, or indirectly, through exposures to unhedged borrowers. Moreover, the high dollarization of most SSA LICs exposes them to the risk of a generalized run on their foreign currency deposits. Given that our proxies for currency mismatch in the banking system’s balance sheet (net open FX position) and for liability dollarization (M2 to reserves) are not statistically significant, we can infer that the channel through which a currency depreciation works in SSA LICs is primarily indirect, i.e. via exposures to FX risk by bank borrowers.  

Our results also show that rapid domestic credit expansion relative to GDP precedes banking crises. This may signal the peak of a credit cycle, where relaxed credit standards and build-up of financial imbalances in the real economy lead to widespread defaults and therefore systemic banking problems. Related to this, we find that the banking system in SSA LICs is crisis-prone if it engages in excessive credit activity relative to the deposit base. In other words, the probability of a systemic banking crisis increases when banks tend to finance an increasing share of their loan portfolio with non-core liabilities, resulting in low liquidity and/or vulnerability to deposit withdrawals.  

Our results have important policy implications at a time when financial regulators and central banks in SSA LICs are reassessing their financial regulatory agenda in the context of recent reforms spurred by the global financial crisis, in particular Basel III. Our findings underline the need to implement an effective macroprudential framework in addition to standard microprudential regulation, monetary policy and administrative measures to address the risks to financial stability emanating from undiversified and dollarized environments. In this respect, SSA LICs’ financial systems might benefit from credit-related measures such as sectoral ceilings on credit exposures and/or credit growth, and higher risk weights and/or provisioning rates on foreign currency lending to ensure adequate protection from concentration risk and currency-induced credit risk.  

In terms of microprudential regulation, implementing the liquidity requirements set out in Basel III might also be a useful complement to existing liquidity rules. On the other hand, our results do not warrant tightened capital requirements, which represent the cornerstone of recent international regulatory reforms. Finally, it is important that financial regulators in the region, with the assistance of international financial institutions, continue efforts to strengthen supervisory capacity, especially in contexts of sustained credit growth, as was the case in Nigeria before the 2009 banking crisis . Ultimately, EWSs are useful tools for policymaking but should never substitute the judgment of financial regulators.  

Pietro Calice is Principal Investment Officer with the African Development Bank

Bank Financing to SMEs in East Africa

27.02.2012Pietro Calice

Small and medium enterprises (SMEs) play a major role in economic development in Africa. Studies indicate that SMEs contribute on average about three-quarters of total employment in manufacturing, when the informal sector is included. A number of factors affect the growth of African SMEs, including the business environment and the quality of the labour force. However, a crucial element in the development of the SME segment is access to finance, particularly to bank financing, given the relative importance of the banking sector across the continent.  

African SMEs are more financially constrained than in any other developing region. Only 20 percent of SMEs in Sub-Saharan Africa have a line of credit from a financial institution compared, for example, with 44 percent in Latin America and Caribbean, and only 9 percent of their investments are funded by banks versus 23 percent in Eastern Europe and Central Asia. It is, therefore, not surprising that the international development community has listed access to finance for SMEs as an important policy priority for Africa.  

In spite of the importance of the topic, relatively little research exists on SME financing from a supply-side perspective.

This is compounded by the fact that comprehensive data on SME finance is still to be more consistently collected and monitored over time. Nonetheless, existing studies conducted in other developing economies show that, contrary to the conventional perception that financial institutions are not interested in dealing with SMEs, banks consider the SME segment as strategically important. Yet institutional constraints remain and the market is far from being saturated.  

In a recent paper co-authored with Victor Chando and Sofiane Sekioua, we shed light on current trends and practices in bank financing of SMEs in four East African countries, namely Kenya, Tanzania, Uganda and Zambia. In particular, the paper forms part of a broader African Development Bank regional project on the topic, whose objective is to identify best practices in SME lending as well as constraints that impede growth in the SME finance market so as to draw relevant policy implications.  

We find that the SME segment is a strategic priority for the banks in the region. SMEs are considered a profitable business prospect and provide an important opportunity for cross-selling. Banks consider that the SME lending market is large, not saturated and with a very positive outlook. A number of obstacles are, however, constraining further banks’ engagement with the SME segment, including SME-related factors such as the lack of adequate information and collateral as well as their largely family-owned structures. Macroeconomic factors, business regulation, the legal and contractual environment, the lack of a more proactive government attitude towards the segment, some areas of prudential regulation and some bank-specific factors are also perceived to negatively affect the SME lending market in East Africa. Nonetheless, banks have adapted to their environment and developed mechanisms to cope with it through innovation and differentiation. Most banks have dedicated units serving SMEs, to which they offer largely standardized products though the degree of personalization is growing. And albeit advanced transaction technologies based on scoring and risk-rating systems remain relatively underdeveloped, banks are gradually automating their risk management frameworks to achieve efficiency gains.  

On the whole, our findings are broadly akin to those of similar studies in other geographical contexts, suggesting that banks in the region have enthusiastically embraced the SME segment and are making substantial investments to develop their relationship with SME clients. This holds good promise to contributing to close the “SME financing gap” which characterizes Sub-Saharan Africa, including East Africa, compared to other developing regions. It is, therefore, important that this trend is supported and encouraged by removing those institutional and policy obstacles that constrain SME lending.  

A necessary condition for the sustainable growth of the SME lending market in East Africa is the presence of a stable macroeconomic environment and a predictable policy regime. The findings of the paper suggest that banks in the region are pursuing the SME segment because of its attractiveness, despite important constraints. In order to ensure that this trend continues uninterrupted, strong macroeconomic performance and a stable and consistent fiscal and monetary framework have been identified as important considerations. It is also important that countries in the region continue their efforts to modernize their financial systems, including the prudential regulatory framework, enhancing competition and innovation so as to give rise to alternative financing providers and financial solutions to better serve the SME segment.  

Reforming the legal and regulatory environment might contribute to increase banks’ involvement with SMEs. A first area of intervention might be the legal framework for creditor rights and for secured lending. Efficiency of the courts and issues surrounding the definition of collateral have been listed as important constraints to the development of the SME lending market. Targeted interventions on the relevant legislation might contribute to speed up enforcement procedures and improve the efficiency of the judiciary. For SMEs, what constitutes acceptable collateral is also an important issue. Reforming the legal framework for secured lending and reviewing the regulatory treatment of collateral would facilitate SMEs to pledge a wider share of their assets as a guarantee for their borrowings. Finally, governments might explore the possibility of introducing a simplified company registration process, which takes into consideration the peculiarities of SMEs compared to larger companies.  

There is also room for optimizing the role of the governments in the region. Current government programs in the SME space are perceived as generally insufficient in supporting the growth of the market. This might be due to the lack of consistency. Governments might therefore consider introducing a dedicated and organic SME policy to boost this segment. A first start should be the adoption of a uniform definition of SME. Most of the banks in East Africa use loan size and turnover as criteria to define SMEs. The adoption of such criteria and their formalization into relevant legislation might ease the attainment of policy objectives. A second area of intervention might include an optimization of current financing support mechanisms, including national and regional development finance institutions, by focusing on additionality and on developing new instruments. In this respect, an assessment of their mandate and their development effectiveness would help fine tune a policy review in this area.  

Finally, a better understanding of the SME segment and the implementation of measures aimed at addressing some of their intrinsic weaknesses should be a further policy priority. Given the crucial importance attributed by banks to SME-specific constraints, priority might be given for example to the collection of statistics and data on their characteristics in order to better understand the demand-side perspective, which is equally important in the development of the SME lending market. Measures in this domain might include the scaling up of capacity building programs and the introduction of incentives for SMEs to formalize.

Pietro Calice is a Principal Investment Officer within the Private Sector Department, Financial Institutions Division, at the African Development Bank (AfDB). In his capacity, Pietro focuses on financial stability and financial inclusion, with a particular emphasis on the intersection between the two dimensions. He covers the financial sector through an appropriate mix of knowledge development and dissemination, selected transactions and policy dialogue. In particular, he has written expensively on the Basel capital accord and its effects on developing economies as well as on access to finance for SMEs. He has designed and implemented innovative financial inclusion initiatives, including the African Guarantee Fund for SMEs. Prior to joining the AfDB, Pietro worked at ratingagencies and investment banks as a credit research analyst.

The macroeconomic impact of Basel III on African economies

25.04.2011Pietro Calice

Africa escaped the recent global financial crisis relatively unscathed. While the region could not avoid the spillover effects of the ensuing global economic downturn, its banking sector proved generally resilient. This was mainly due to the structural reforms implemented over the past decade, including strengthening the relevant regulatory and supervisory systems, within a sounder and more flexible macroeconomic management framework.

Against this background, countries in the region need to advance their financial sector reform agenda. While financial deepening and access to financial services remain the main policy objectives, sustainable and inclusive economic growth rests ultimately on financial stability. In this context, the recent global regulatory response to the financial crisis, in particular the Basel Committee on Banking Supervision’s reform package known as Basel III offers a valuable opportunity to reexamine Africa’s financial sector reform agenda.

Basel III introduces a comprehensive set of measures which complements the Basel II and Basel I frameworks, with the aim to improve the resilience of banking systems. The cornerstone of Basel III is higher and better quality capital, mostly common equity, with improved absorption features, complemented by newly introduced liquidity requirements.

Africa is making important efforts to move to Basel II and might benefit from implementing Basel III. In spelling out a strategy to move to new standards however, it is important to assess the implications of regulatory reforms on economic performance, particularly of higher capital requirements, given their potential impact on macroeconomic outcomes. The existence of a “bank capital channel” through which changes in bank capital regulation have macroeconomic effects is well documented in the literature.

In a paper coauthored with Giovanni Caggiano from the University of Padua, we estimate the long-run impact of tightened capital ratios on African economies. Adopting a methodology used in similar studies, we quantify the gross benefits in terms of gains in African GDP resulting from a reduced probability of future banking crises. Based on existing data on the historical frequency of systemic banking crisis and associated output losses in Africa, we map higher capital ratios into reductions in the probability of crisis using a multi-variate logit model for a panel of 19 countries over the period 1980-2008. We then estimate the long-run economic costs of higher capital requirements on output assuming that an increased cost of funding is passed on fully to final customers through higher spreads. We employ two panel data for 22 countries over the period 2001-2008. In the first model, we analyze the long-run relationship between capital requirements and lending spreads. In the second model, we examine the long-term relationship between lending spreads and GDP. We finally combine the calculations so derived to quantify the net effect of higher capital requirements on the output of African economies.

We find positive net benefits from regulatory capital tightening. Starting from different levels of capitalization of the banking sector reflecting different initial conditions, net benefits for Africa are however found to be lower than those estimated for advanced economies. This is due to both lower expected gross benefits and costs for African economies, suggesting that with an already strongly capitalized banking system the marginal benefit of higher capital may be relatively moderate.

Our findings would suggest that heightened capital requirements under Basel III are not a priority for Africa. Therefore, as African countries advance their financial sector reform agenda, they might want to emphasize other areas which are equally critical to financial stability. These might include, among others: i) improving timely disclosure of high quality information, including comprehensive and internationally accepted accounting principles; ii) promoting the adoption of a sound corporate governance framework in order to achieve and maintain public trust and confidence in the banking system; iii) increasing compliance with the Basel Core Principles for Effective Banking Supervision, particularly with those requirements with which many countries are materially non-compliant, namely the independence of the supervisor and its capacity to enforce regulation and take corrective measures; iv) strengthening the relevant legal and institutional framework, introducing a crisis management system and resolution process, including a carefully designed deposit insurance system.

As a caveat, it is important considering that our results are subject to substantial uncertainties. Data and model limitations as well as the difficulty of mapping capital ratios in reductions of the probability of banking crisis are factors which inevitably affect our results. Moreover, we have omitted several elements from our analysis which may be important. Specifically, our assessment would benefit from considering the impact of higher capital requirements on African GDP volatility. Another dimension which would enrich our assessment is the expected impact on African macroeconomic performance from tightened capital rules in the rest of the world. With this in mind, our study provides a broad overview of the long-term economic impact of higher capital requirements on African economies.

Pietro Calice is a Principal Investment Officer at the African Development Bank.


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