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Financial sector research in Africa – looking forward

11.11.2013Thorsten Beck

It is about two years ago that the AfDB, GIZ and World Bank published the Financing Africa book, a broad analysis of trends in Africa's financial systems, of gaps and challenges, and of different policy options. For researchers focused on Africa's financial systems, the past years have been exciting, with many different forms of innovations being introduced and assessed. But there have also been new challenges for analysts and policy makers alike, as I will lay out in the following. Cooperation between different stakeholders, including practitioners, donors, policy makers and researchers can help move forward the frontier for Africa's financial systems. In the following, I will focus on five areas where more data and more research can support better informed policy making.

Long-term finance

One first area is that of long-term finance, which can be seen as the second (next to lack of financial inclusion) critical dimension of shallow financial markets in Africa. As documented in the Financing Africa publication, there is a bias on banks' balance sheets toward short-term liabilities and, more critically, short-term assets, only few countries have liquid equity and debt markets, and there is a dearth of effective contractual savings institutions, such as insurance companies, pension funds and mutual funds. This dearth of long-term financial intermediation is in contrast to the enormous need for long-term financing across the continent, for purposes of infrastructure, long-term firm financing for investment and housing finance.

The long-term finance agenda is an extensive one, both for researchers and policy makers. First, there is still a dearth of data on long-term financing arrangements, including on corporate bond market structures and costs, insurance markets and private equity funds. Second, identifying positive examples and gauging interventions and policies will be critical, as will be expanding to Africa the small literature on equity funds and their effect on enterprises that exists for U.S. and Europe and (increasingly) for emerging markets. One important constraint mentioned in the context of long-term finance is the lack of risk mitigation tools. Partial credit guarantees can play an important role, but their design and actual impact has not been studied sufficiently yet.

Small enterprise growth

A second important challenge is that of extending the financial inclusion agenda from micro- up to small enterprises, both in terms of supply- and demand-side constraints. The emphasis stems from the realization that job-intensive and transformational growth is more likely to come through formal than informal enterprises. Assessing different lending techniques, delivery channels and organizational structures conducive to small business lending is important, as is assessing the interaction of firms' financing constraints with other constraints, including lack of managerial ability and financial literacy. This research agenda is important for both financial institutions and policy makers. For financial institutions, the rewards can lie in identifying appropriate products for small enterprises and entrepreneurial constraints that might prevent take-up and impact repayment behavior by small enterprises.

For policy makers, the rewards can lie in identifying policies and institutions that are most relevant in alleviating small firms' growth constraints.

Regulatory reform agenda

A third important challenge refers to regulatory reform. While global discussions and reform processes are driven and dominated by the recent Global Financial Crisis and the fragility concerns of economies with developed if not sophisticated financial markets, Africa's fragility concerns are different and its reform capacity lower. Some of the suggested or implemented reforms seem irrelevant for almost all African countries (such as centralizing over-the-counter trades) or might have substantially worse effects in the context of shallow financial markets than in sophisticated markets increasingly dominated by high frequency trading (such as securities trading taxes). Prioritizing regulatory reforms according to risks and opportunity costs for financial deepening and inclusion is therefore critical in the definition of the regulatory reform agenda for African countries. While not necessarily an area for fundamental academic research, financial sector researchers can contribute to this conversation by helping identify regulatory constraints for financial deepening and broadening and potential sources for stability risks, based on past experiences from Africa and other regions.

Cross-border banking

A fourth important challenge is that of cross-border banking and the necessary regulatory framework. Identifying cross-border linkages between countries is critical, and data collections, such as by Claessens and van Horen (2014), represent an important first step. Understanding the channels through which cross-border banking can help deepen financial systems and foster real integration, and the channels through which cross-border banks can threaten financial stability, is critical. In this context, the optimal design of cross-border cooperation between regulators and supervisors to minimize risks from cross-border banking while maximizing its benefits is important (Beck and Wagner, 2013). African supervisors have been addressing the challenge of regulatory cooperation both on the bi-lateral and sub-regional level as well as on the regional level, with the establishment of the Community of African Bank Supervisors. Financial research can support this cooperation and integration process.

The politics of financial sector reform

A final important area is the political economy of financial sector reform. Short-term political interests and election cycles undermine the focus on long-term financial development; interests to maintain the dominant position of elites undermine the incentives of governments to undertake reforms that can open up financial systems and, thus, dilute the dominant position of the elites. On the other hand, the financial sector is critical for an open, competitive, and contestable economy because it provides the necessary resources for new entrants and can thus support economic transformation. Better understanding the political constraints in financial sector reforms and identifying windows of opportunity are therefore important. Focusing on the creation of broader groups with a stake in further financial deepening can help develop a dynamic process of financial sector reforms. An increasing literature has tried to understand the political economy of financial sector reform in developed and emerging markets; extending this literature to Africa can support the optimal design of financial sector reform programs.

Conclusions

Research in these five areas will have to be supported by an array of new data and a variety of methodological approaches. This implies expanding data availability towards non-bank providers, such as equity funds, but also exploiting existing data sources better, including credit registry and central bank data sets. In addition to exploiting more extensive micro-level data sets, a variety of methodological approaches is called for. I would like to point to just two of them. First, randomized experiments involving both households and micro- and small enterprises will shed light on specific technologies and products that can help overcome the barriers to financial inclusion in Africa. One of the challenges to overcome will be to include spill-over effects and thus move beyond partial equilibrium results to aggregate results. Second, further studies evaluating the effect of specific policy interventions can give insights into which policy reforms are most effective in enhancing sustainable financial deepening and positive real sector outcomes.

For research to succeed in obtaining the necessary data, asking relevant questions but also maximizing its impact, a close interaction between researchers and donors, practitioners and policy makers is necessary. This relationship can often be critical for obtaining micro-level data, such as from credit registries or specific financial institutions, or for undertaking experiments or RCTs. However, these links are also critical for disseminating research findings and having an impact on practice and policy in the financial sector.

 

Thorsten Beck is Professor of Banking and Finance at Cass Business School in London and Professor of Economics at Tilburg University in the Netherlands. He was the founding chair of the European Banking Center at Tilburg University from 2008 to 2013. Previously he worked in the research department of the World Bank and has also worked as consultant for - among others - the IMF, the European Commission, and the German Development Corporation. His research and policy work has focused on international banking and corporate finance and has been published in /Journal of Finance/, /Journal of Financial Economics/, /Journal of Monetary Economics/ and /Journal of Economic Growth/. His research and policy work has focused on Eastern, Central and Western Europe, Sub-Saharan Africa and Latin America. He is also Research Fellow in the Centre for Economic Policy Research (CEPR) in London and a Fellow in the Center for Financial Studies in Frankfurt. He studied at Tübingen University, Universidad de Costa Rica, University of Kansas and University of Virginia.

References and further readings

Beck, Thorsten, 2013a. Finance, Growth and Fragility: The Role of Government. CEPR Discussion Paper 9597.

Beck, Thorsten, 2013b. Finance for Development: A Research Agenda. Research Report for ODI.

Beck, Thorsten and Robert Cull, 2014. Banking in Africa, in: Berger, Allen, Phil Molyneux and John Wilson (Eds.): Oxford Handbook of Banking, 2nd edition.

Beck, Thorsten, Samuel Munzele Maimbo, Issa Faye, and Thouraya Triki, 2011. Financing Africa: Through the Crisis and Beyond. Washington, DC: The World Bank.

Beck, Thorsten and Wolf Wagner, 2013, Supranational Supervision: How Much and for Whom? CEPR Discussion Paper 9546.

Claessens, Stijn and Neeltje van Horen. 2014. Foreign Banks: Trends and Impact. Journal of Money, Credit and Banking, forthcoming.

Finance in Africa – A new focus on users

20.11.2011Thorsten Beck

Most of the discussion on financial deepening and broadening focuses on financial institutions and markets and thus on the supply side.  And it is natural to start the analysis here, as that is where traditionally data have been. Similarly, regulators focus on financial institutions and markets as natural starting point. Looking at the big picture, however, we care about the users and beneficiaries of financial services.  We care about enterprises that need external financing for working capital and investment. We care about households that need access to payment and deposits services. We care about risk management services for both households and enterprises. Only in a second instance do we care about who provides these services.  In the recent Financing Africa flagship report, my co-authors and I therefore emphasize the need for increased focus on users, with important repercussions for both analysis and policy.  

This increased focus on users is supported by recent data collection exercises for both enterprises and individuals that have allowed a closer look at users and non-users of financial services, understanding both supply and demand-side barriers and the extent of use. However, it also requires a reorientation in regulatory approaches, as I will discuss in the following.   What does a closer focus on users imply? First, it implies an increased effort at financial literacy, i.e. knowledge about products and capability to make good financial decisions, both for households and enterprises. There is often a lack of awareness about available financial products, as well as a lack of capability to manage resources well, knowing to evaluate and compare different financial products and services, and demanding one’s rights if necessary. 

Specific activities in this area might include the design of graphic tables with comparative information on the full pricing of financial products, community and village road shows to explain major financial concepts, training on the delivery of financial education by retail officers, financial literacy messages in m-banking systems, campaigns on new pension systems, basic brochures on financial services, the inclusion of financial literacy in school curricula, campaigns on the management of debt and the avoidance of over indebtedness, and campaigns on the economics and the benefits of the insurance market. A lot has happened in this area in recent years, but significantly more research and analysis is needed to explore what kind of program targeted of which population group can be helpful.  

Second, there is a general trust issue. Overcoming households’ mistrust of financial institutions might be easier in the case of transaction services, where the inter temporal nature of financial services is reduced to a few minutes, especially in m-banking, especially in the case of mobile phone banking, in contrast to savings or credit services, where the result can only be seen after months if not years. The rapid success of m-banking services focusing on payment and remittance services in several African economies has shown the promise of using transaction services as entry point for the inclusion agenda.  

Third, an increased focus on users implies more tailor-made products for the bottom of the pyramid. Transaction accounts, often linked to the use of ATMs rather than shiny banking halls, might be more attractive and cheaper for large part of the currently unbanked population. Agency banking, i.e. financial service provision through non-financial institutions, such as supermarkets or gas stations – a success in Latin America - can help overcome geographic and cultural barriers. Linking with informal financial service providers and microcredit institutions can also help barriers between banks and users.  

Fourth, for enterprises, a focus on users refers mostly to the challenge of turning investment into bankable projects. Standard barriers include the lack of collateralizable assets and audited financial statements. To address the lack of collateral one has to look beyond the upgrade of property registries – part of the necessary infrastructure of any modern financial system, but a rather long-term goal; products tailored for SMEs such as leasing or factoring rely less on traditional collateral. Combining lending with extension services for entrepreneurs can be promising.  

Standard accounting rules are too much of a burden for most SMEs. There might a need for the development and implementation of simplified accounting standards for microenterprises and for SMEs.  

Fifth, it is important to stress that financing is only one of the many obstacles that African enterprises face in their operation and growth. African firms report greater obstacles than firms outside Africa in access to land, customs and trade regulations, transport, and, most strikingly, electricity. This points to the deteriorated physical infrastructure that African enterprises have to deal with, as well as the deficiencies in the broader regulatory environment, and thus a broader reform agenda than financial sector reforms.  

While a focus on users is important in the financial deepening and broadening agenda, it is as important in the financial stability agenda. We care about stability of financial systems not for the sake of bankers and stock market traders, but for the sake of users. 

This implies consumer protection, including (1) consumer disclosure that is clear, simple, easy to understand, and comparable; (2) prohibitions on business practices that are unfair, abusive, or deceptive and (3) efficient and easy-to-use recourse mechanisms.    

On a more general level, it might have to imply a rethinking of supervisory focus. The decision to extend regulation and supervision to non-bank segments of the financial system has to take into account the need for protection by different users. We therefore advocate a caveat emptor approach for segments of financial markets with mostly sophisticated users, such as equity funds and over-the-counter segments of capital markets, whereby the weight of the responsibility for monitoring lies on sophisticated investors rather than supervisors. For bottom-of-the pyramid segments, on the other hand, we advocate an increased supervisory focus, especially in the case of deposit-taking institutions. Experiences from low- and middle-income countries have shown the risk that pyramid schemes and their collapse can pose for socio-economic stability.  Beyond regulation and supervision of deposit-taking institutions and conduct of business regulations for non-deposit taking institutions, this implies increased consumer protection as outlined above.  

The increased focus on users is thus a broad agenda. As with the rest of the financial sector agenda, one size does not fit all. While South Africa has established a multi-tiered consumer protection framework, the institutional demands for such a framework might be too large for many small low-income countries, where simpler versions, maybe based on industry self-monitoring, might be necessary. Regulation and supervision of many small microfinance institutions can be costly in many African countries with limited supervisory resources, using apex structures can be helpful in this context.

Africa needs more financial innovation!

12.09.2011Thorsten Beck

In the industrialized countries of North America and Western Europe, financial innovation has acquired a bad connotation after the recent crisis, being associated with CDO, CDS and other three-letter abbreviations, which few understand.  However, innovation is more than that and comprises numerous new products, new processes and new organizational forms. As I will argue in the following, innovation can be an enormously positive force, even in the financial system and especially in Africa.  However, in order to reap the benefits of more innovation, a different regulatory approach is needed than currently present in most African countries. 

Financial innovation comprises a variety of new products, new processes and new organizational forms that can help reduce transaction costs, provide better risk management tools and overcome information frictions.  Recent examples in Africa include (i) mobile banking, i.e. access to basic payment services through mobile phones, even without having to have a bank account, (ii) the use of psychometric assessments as a viable low-cost, automated screening tool to identify high-potential entrepreneur, (iii) agricultural insurance based on objective rainfall data, and (iv) new players in the financial systems, such as micro-deposit taking institutions, and cooperation between formal and informal financial institutions. Examples from other regions include agency agreements between banks and non-financial corporations (supermarkets, post offices etc.) to deliver financial services to remote and low-income areas, joint platforms for banks to provide factoring services to small enterprises, and private-public partnerships for infrastructure, often supported by international risk mitigation mechanisms.  

Financial innovation can be critical in overcoming the two main challenges that financial intermediation faces in Africa: the high costs and the high risks.  Take the example of mobile banking. First, it relies to a greater extent on variable rather than fixed costs, which implies that even customers who undertake small and few transactions are viable or bankable relative to banking through conventional channels. Second, trust can be built much more easily by reducing the risk from the customer’s and the provider’s viewpoint. Financial innovation can thus be critical in helping reduce the large share of population that is currently unbanked in Africa.  Similarly, new institutions and new products can help overcome the challenge of long-term financing in Africa.

How does financial innovation come about?  First of all, incumbent financial institutions are rarely interested in innovating unless forced to do so by competitive pressure.  Africa’s banking systems, however, are mostly small and of limited competitiveness. Second, financial innovation cannot be introduced per regulation. It is introduced by market players – mostly private, though not always profit-oriented. Such innovation often comes from unexpected quarters. In Kenya, Equity Bank transformed itself from an underperforming building society into an innovative bank and is now the largest bank in the country in terms of clientele. It did this by offering new delivery channels, such as mobile branches, by targeting a new clientele, and by focusing on the quality of service delivery. These experiences suggest that an open, contestable banking system is needed and that new providers might come from outside the established market. 

There are different approaches towards innovation.  The traditional regulatory approach is that of “proper sequencing” - legislation-regulation-innovation. This process can take years, however. An alternative approach is one of try-and-see or test-and-see, as applied by regulators in Kenya with respect to M-Pesa. Such an approach is not be confused with a laissez-faire approach. It requires an open and flexible regulatory and supervisory approach that balances the need for financial innovation with the need to watch for fragility emerging in new forms. Such an approach can take into account the unexpectedness of innovation, in terms of needs, technical possibilities and origin.

In the forthcoming Financing Africa: Through the Crisis and Beyond flagship report, my co-authors and I advocate for the second approach, one of a more open regulatory mindset. This does not mean that there should be an open-door regulatory environment to permit all and sundry to offer deposit-taking services and that regulatory authorities stand by silently as the financial system is changed through innovation. On the contrary, the success of M-Pesa and the possible dominance of the mobile payment market by Safaricom show the need for an active regulatory approach to prevent the potential entrenchment of a monopolist. Similarly, excesses in payroll lending – an innovation initially welcomed for extending credit services to previously unbanked - show the need for an active approach to consumer protection to avoid overindebtedness on the household side and financial fragility on the supplier side.

Such a more open regulatory mindset towards innovation also implies looking beyond the banking system and incumbent financial institutions towards new potential providers.  Ultimately, we care about the users of financial services – enterprises, households and governments. If current providers cannot provide the necessary services, look beyond them to new institutions, even if outside the financial system.  This imposes higher strains on regulators as they have to supervise more according to services rather than institutional categories, but can come at a great benefit.  

When evaluating new products and new delivery channels, regulators often cite concerns related to Know-Your-Customer (KYC) requirements, put in place for Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) purposes.  More recently, regulators around the world, however, have moved towards a risk-based approach. Thus, for example, South Africa lowered the documentation barriers on basic financial products subject to monetary limits and certain other conditions, including that clients be natural persons, South African nationals, or residents and that the transactions be domestic.

In summary, Africa can benefit from financial innovation, both in extending access to financial services and in extending the maturity of financial contracts. To reap such benefits, however, a different regulatory mindset is needed.

 

Thorsten Beck is Professor of Economics and Chairman of the European Banking Center. Before joining Tilburg University and the CentER, he worked at the Development Research Group of the World Bank. 

His research and policy work has focused on two main questions: What is the effect of financial sector development on economic growth and poverty alleviation? What are the determinants of a sound and effective financial sector? Recently, his research has focused on access to financial services by small and medium-sized enterprises and households. He is co-author of "Making Finance Work for Africa" and "Finance for All? Policies and Pitfalls in Expanding Access" and lead author of the forthcoming joint AfDB-GIZ-World Bank report “Financing Africa: Through the Crisis and Beyond.” His country experience in both research and policy work includes Bangladesh, Bolivia, Brazil, China, Colombia, Egypt, Mexico, Peru, Russia and several sub-Saharan African countries. 

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