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Are Anti–Money Laundering Policies Hurting Poor Countries? – New CGD Working Group Report

30.11.2015Clay Lowery and Vijaya Ramachandran, Center for Global Development

In 2009, G-8 Leaders set a goal of reducing remittance costs to 5 percent within 5 years, roughly a 5 percentage point decrease. Instead, the cost of sending remittances from G-20 countries to "high risk" countries has stayed almost flat, and to "less risky" countries, has decreased slightly more than 1 percentage point.

Last month, the Financial Stability Board (FSB) - which coordinates and reviews the work of the international standard setting bodies in the area of financial regulation - published a report to the G-20 stating that in a survey carried out by the World Bank, roughly half of emerging market and developing economies have experienced a decline in correspondent banking services, which allows for banks to make and receive international payments.

In other words, despite the laudable G-20 policy goal of achieving more inclusive economic growth, there appears to be a disturbing trend of banking services declining or, at least, not becoming more cost effective for some countries. Why do we see these trends in remittance costs and correspondent banking relationships? A new CGD report - the outcome of a working group of policymakers, academics and individuals from the private sector - says that one reason (and we emphasize that it is not the only driver) might be that these trends are the unintended consequences of anti-money laundering / combating the financing of terror (AML/CFT) policies in rich countries.

Under current AML/CFT rules, banks are asked to prevent sanctions violations and assess and mitigate money laundering and terrorist financing risks, or face penalties. However, regulators sometimes send mixed signals about whether and how banks and other entities should manage these risks, which can result in simplistic risk assessment methodologies being applied by these entities. There may also be a chilling effect resulting from the imposition of legitimate fines on some large banks for egregious contraventions of AML/CFT rules and, particularly, sanctions laws. These factors, along with others, have led banks to adopt an understandably conservative position. This includes exiting from providing services to firms, market segments and countries that are seen as higher risk, including money transmitters, banks in poor countries and non-profit organizations.

Let us illustrate our findings with an example. In 2013, Barclays closed the accounts of nearly 90% of its UK-based money transfer organizations. It was the last large bank in the country willing to provide accounts to the money remitters that are a lifeline for migrants trying to send funds to families in poor countries. This wasn't the first time that a bank decided to withdraw nearly wholesale from the remittances sector - a process known as 'de-risking' (see Figure 1). Nor will it be the last.

At a time when remittances are worth more than three times total foreign aid flows, these kinds of actions could have a significant impact on individuals - and entire countries. It's not just migrant worker families that suffer from 'financial abandonment.' As stated earlier, banks in poor countries find themselves cut off from correspondent banking services: trade finance, clearing and settlement, cash management, and international wire transfers; while non-profit organizations (NPOs) are often unable to obtain banking services thereby hampering their work, especially those NPOs associated with 'high risk' areas that are often home to the world's poorest and most vulnerable people.

Figure 1: The Widespread De-Banking of Remittance Providers

Such unintended consequences are causing concern at the highest levels: both Federal Reserve Chairwoman Janet Yellen and Bank of England Governor and Financial Stability Board Chairman Mark Carney acknowledge the very real problems of de-risking. Standards setters, such as the Financial Action Task Force (FATF, the global standard setting body for AML/CFT), and regulators have acknowledged the existence of de-risking and are starting to work to address it. In the meantime, the losers are manifold.

Who are the losers?

  • Migrant workers and their families. For the remittance system to work effectively there must be a healthy money transfer sector. Money transfer organizations (MTOs) are seeing banking services denied, downgraded, or made more expensive. In other words, MTOs are pushed out of one bank and have to find another that may be more expensive, or based in a less transparent jurisdiction. This leaves only larger money transfer organizations with access to bank accounts, which can raise the cost of sending remittances. Industry bodies report that many smaller players have been forced to close, become agents of larger businesses, or even disguise the true nature of their operations in order to remain banked. Given that remittances from migrant workers total $440bn a year, a vital source of finance for poor countries might be affected.
  • People in post-disaster or conflict situations. Vulnerable people in post-disaster or conflict situations rely on non-profit organizations to deliver humanitarian assistance. However, NPOs are reporting difficulties in carrying out operations. For instance, HSBC closed the bank account of several NPOs including the Cordoba Foundation, a think tank that receives money from the UK government for work to prevent terrorism, saying only that continuing to bank the organization 'fell outside the bank's risk appetite'.
  • Small to medium-sized firms. These enterprises are crucial to the economy in poor countries but they often lack the credit they need to conduct operations, grow their businesses, and create jobs. To get access to this credit, they often need local banks to have the ability to conduct cross-border transactions to make and receive international payments. Unfortunately, developed country banks increasingly report withdrawing correspondent banking services from banks in high-risk jurisdictions, including many poor countries, reducing their access to the global financial system.
  • People in rich and poor countries alike. Public safety and economic stability in both rich and poor countries rely on financial regulators and law enforcement having visibility of transactions. However, such agencies increasingly find it difficult to track transactions. This is because MTOs who cannot send funds electronically begin to use potentially less transparent mechanisms like bulk currency exchanges. Transparency is also reduced when banks and businesses in poor countries have to send funds via banks operating in less transparent jurisdictions.

What can be done?

Our report puts forward five recommendations that would require action by national regulators, international standard setters, international organizations, and private institutions to work toward a solution. These are the first steps that must be taken toward solving the problem:

  1. Rigorously assess the unintended consequences of AML/CFT and sanctions enforcement at the national and the global level. The strength of the suggestive evidence detailed in the report requires a rigorous causal investigation of the unintended consequences of AML/CFT conducted by the relevant international institutions as specified in the report.
  2. Generate better data and share existing data between institutions. In order to assess unintended consequences rigorously, more and better data should be generated through private and public sector efforts that we elaborate upon in the report.
  3. Strengthen the risk-based approach. FATF should be congratulated for introducing and recently strengthening its risk-based approach. However, it needs to be implemented more extensively and more consistently.
  4. Improve compliance and clarify indicators of lower risk. Compliance procedures at many NPOs and MTOs must be improved so as to be more effective. At the same time, more needs to be done to recognize those NPOs and MTOs that do have effective systems in place, including better supervision of MTO sectors at the country level.
  5. Facilitate identification and lower the costs of compliance. National governments, banks and the World Bank should accelerate the adoption of new and existing technology such as Legal Entity Identifiers and biometric ID to facilitate lower cost customer identification, and enable "know your customer" compliance and due diligence while still protecting individual privacy.

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This post was originally published on the Center for Global Development website. 

Clay Lowery is a visiting fellow at CDG. He currently serves as Vice President for Rock Creek Global Advisors, an international advisory firm that assists clients to anticipate and seize opportunities in the global marketplace, while mitigating political and regulatory risk. 

Vijaya Ramachandran is a senior fellow at the Center for Global Development. She works on private sector development, financial flows, food security, humanitarian assistance and development interventions in fragile states.

Banking and Finance in Africa

16.11.2015Dhafer Saïdane and Alain Le Noir, Club des Dirigeants de Banques

For over a decade now, Africa has been experiencing a higher growth rate compared to the rest of the world. Many African countries are being strengthened by a wave of reforms in all sectors, which favours market mechanisms, the state's disengagement from the economic and social domain, and fair price. Yes, Africa is undoubtedly the world's next emerging market.

At the heart of Africa's economic growth is its financial system, considered to be one of the continent's brightest prospects. Indeed, Africa's banking system have showed better performance in 2014 (24%), six times the average return of European banks.

In an effort to unravel the mystery of Africa's growth and progress in the 21st century, we will be launching a new book entitled "Banque et Finance en Afrique: les acteurs de l'émergence", to be published under the Revue Banque edition. The publication, an initiative by the African Bankers Club (Club des dirigeants des banques et des établissements de credit d'Afrique), will feature comprehensive analysis of Africa's banking and financial sector, through collective works gathered from the continent's economic and financial experts. The book will be launched in January 2016, and includes a preface by Christian de BOISSIEU and Arnaud de BRESSON.

What does the current African landscape looks like? What are the strategies implemented by the major African banks? What is the status of pan-African banking and what is its future? What are the major challenges for the African banking regulator? What are the major challenges facing African banks in the next thirty years?

These are just some of the questions analysed in this book, which will also look to address other regulatory issues and their degree of adaptation, particularly in dealing with money laundering.

We believe that the economic development of Africa will be greatly facilitated by the free flow of ideas and research across the entire continent. This book aims to share those insights and builds on the experts' deep experiences and knowledge of the continent.

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Collective work under the direction of: 

Dhafer Saïdane, University of Lille North of France, SKEMA Business School, and Adviser to the African Bankers Club (Club des Dirigeants des Banques et Établissements de crédit d'Afrique); and

Alain Le Noir, Founder and Special Advisor to the President of the African Bankers Club (Club des Dirigeants des Banques et Établissements de crédit d'Afrique).

Take advantage of the special subscription offer available until November 30th, 2015. 

Gravatar: Florian Léon

How does the expansion of regional cross-border banks affect bank competition in Africa?

01.06.2015Florian Léon

African banking sectors have witnessed significant changes in their structure over the past several decades with the penetration of regional cross-border banks. We have investigated whether these changes have led to more competition in the banking industry.

The entry of foreign banks increases the number of players and therefore, is likely to increase competition in the banking sector. Moreover, cross-border banks have a comparative advantage when entering new markets in terms of better access to capital, risk diversification, scale economies, skill and management expertise. In particular, foreign banks that originated from Africa have an additional competitive advantage in dealing with countries sharing similar institutional, cultural and economic characteristics. These banks could thus adopt more aggressive strategies to gain market shares.

Several factors, however, may limit the ability of African cross-border banks to increase competition in host markets. The effect of foreign banks entry on competition is conditional to market strategies and the degree of engagement of the regional banks in host countries. For instance, the entry of new banks can exert no effect on competition if these banks follow their clients abroad or focus on a fringe demand that is not financed by domestic banks. Thus, a foreign bank might become a dominant player and reduce contestability. In addition, the multi-market contact theory documents that firms interacting in several markets have more incentives to collude. Therefore the fact that cross-border banks interact in different national markets may reduce their willingness to compete.

To investigate how the expansion of regional banks in Africa has affected banking sector competition, we compared the evolution of competition and the market share of African cross-border banks over the period 2002-2009 in a sample of seven West African countries (Benin, Burkina-Faso, Côte d'Ivoire, Mali, Niger, Senegal, Togo). We used 3 different measures of competition: the Lerner index, the Panzar-Rosse H-statistic and the Boone indicator. Countries under consideration in this study, which are all members of the West African Economic and Monetary Union (WAEMU), have a major advantage for our purpose. Since the mid-2000s, the WAEMU banking landscape has changed dramatically with the arrival and expansion of new banks from Africa. African cross-border banks began their expansion in the WAEMU ten years ago, whereas this change has occurred very recently elsewhere in the continent.

The findings of this study reveal that the penetration of regional banks goes hand-in-hand with more competition among banks. The results show that the degree of competition has increased since the mid-2000s.

Put differently, the expansion of regional banks seems to spur competition in Africa. These preliminary results should be confirmed by a more rigorous test including more African countries. In addition, further research should analyse the consequences of the development of cross-border banks on banking efficiency, stability and inclusion in Africa.

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This blogpost is based on the paper "Has competition in African banking sectors improved? Evidence from West Africa", prepared by Florian Léon from the University d'Auvergne - CERDI.

Gravatar: Paola Granata, Katie Kibuuka and Yira Mascaro

Reducing the Cost of finance and Enhancing Financial Inclusion in Africa: Policy Options

18.05.2015Paola Granata, Katie Kibuuka and Yira Mascaro

On average, lending spreads are higher in Africa than in other developing countries. Several government have reacted by establishing lending rate caps, yet these administrative measures can be counterproductive because interest rate ceilings do not ensure lower long-term lending rates and can adversely affect financial inclusion. In fact, lending institutions can react by simply increasing other service costs to recoup lost income. Moreover, lenders can stop servicing riskier segments of the market (such as MSMEs) if the cap does not adequately compensate operating and other costs.

In a recent paper "The Cost of Financing in Africa: Policies to Reduce Cost and Enhance Financial Inclusion", we analyse the main components of spreads and explore a wide set of reforms that can help lower the cost of finance and ultimately increase financial inclusion while avoiding the negative effects of interest rate controls.

In a nutshell, we found that operating costs and mainly personnel costs tend have the lion's share of spreads in African countries (akin to other developing countries). This may be the result of combination of typical features of African financial systems such as concentrated banking systems, high lending risk premia, and higher upfront investment requirements to expand outreach. We also found that investment patterns have a significant effect on lending spreads. African banks tend to invest relatively more in government securities, perhaps reflecting higher profitability compared to lending operations that inherently incur much larger expenses and carry more risks, particularly in some African countries. Therefore, lending interest rates can be driven upwards to compensate for the opportunity cost of investing in securities.

We argued that policy makers have a wide set of policy reforms at their disposal to lower the cost of finance (and increase financial inclusion) while avoiding the negative effects of interest rates controls. In the paper, we group these policies into seven categories: (I) production/operating costs, (II) regulatory costs; (III) credit risk; (IV) alternative banking business; (V) profitability and return on capital; (VI) macroeconomic stability and country risk; and (VII) enhancing financial inclusion. The list of reforms presented in the paper (and related country examples) is not exhaustive, but it is intended to illustrate the wide array of options available when seeking to lower the cost of finance.

Policy makers aiming to reduce financing costs should prioritize reforms that promise the biggest impact based on country circumstances. Policies related to operating costs and profits could potentially have a big impact given their large share in the interest rate spreads. Accordingly, the following measures are crucial: improving the business environment to reduce transaction costs, such as: improving insolvency/creditor rights and suitable collateral frameworks; promoting agency and mobile banking to reduce costs associated with increased access in rural and scarcely populated area; reducing the cost of borrower information (e.g. through effective credit information systems). Reducing infrastructure costs and insecurity are also key measures to reducing operating costs in Africa. And, increasingly relevant, promoting non-bank financial institution growth enhances competition and contestability within the banking sector while directly increasing financial inclusion of underserved segments (for a more complete list please see paper).

 

This blogpost is based on the paper "The Cost of Financing in Africa: Policies to Reduce Cost and Enhance Financial Inclusion", prepared by Paola Granata, Katie Kibuuka, and Yira Mascaró from the World Bank.

Gravatar: Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu, and Etienne B. Yehoue

Status and Development of Islamic Finance in Sub-Saharan Africa

09.03.2015Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu, and Etienne B. Yehoue

The Islamic finance industry has been growing rapidly in various regions, and its banking segment has become systemic in some countries, with implications for macroeconomic and financial stability. While not yet significant in Sub-Saharan Africa (SSA), several features make Islamic finance instruments relevant to the region, in particular the ability to foster SMEs and micro-credit activities. In a recent paper, we provide a survey on Islamic Finance in SSA where on-going activities include Islamic banking, sukuk issuances (to finance infrastructure projects), Takaful (insurance), and microfinance. Should they wish to develop the market, policy makers could introduce Islamic financing windows within the conventional system and facilitate sukuk issuance to tap foreign investors. The entrance of full-fledged Islamic banks would require addressing systemic issues and adapting crisis management and resolution frameworks.

The financial sector in SSA has been growing rapidly in the past two decades. New products have been introduced and financial institutions are playing an increasing role in financial intermediation, including cross-border financial intermediation.

However, Islamic finance remains small, although it has potential given the region's demographic structure and potential for further financial deepening. As of end-2012, about 38 Islamic finance institutions-comprising commercial banks, investment banks, and takaful (insurance) operators-were operating in Africa. Out of this, 21 operated in North Africa, Mauritania and Sudan, and 17 in Sub-Saharan Africa.

Botswana, Kenya, Gambia, Guinea, Liberia, Niger, Nigeria, South Africa, Mauritius, Senegal and Tanzania have Islamic banking activities. There is also scope for development in Zambia, Uganda, Malawi, Ghana and Ethiopia, as all but Zambia has relatively large Muslim populations-Zambia is interested in using Islamic finance instruments to fund investment in the mining sector. In Uganda, the central bank has started the process of amending its banking regulations to allow for the establishment of Islamic banks and three Islamic banks have applied for a license.

Islamic finance is still at a nascent stage of development in SSA. The share of Islamic banks is small, and Islamic capital markets are virtually non-existent (there were small Sukuk issuances in Gambia and Nigeria). At the same time, the demand for Islamic finance products is likely to increase in coming years. At present, about half of the region's total population remains to be banked. Furthermore, the SSA Muslim population, currently at nearly 250 million people, is projected to reach 386 million in 2030 and financial activities are expected to rise as a share of GDP. Many countries are expected to introduce Islamic finance activities side-by-side conventional banking. Opportunities for the development of Islamic finance are expected to comprise retail products to small and medium-sized enterprises. The sub-continent's growing middle class, combined with its young population is an opportunity for Islamic finance to expand its services. SSA's large infrastructure needs will also provide an opportunity for Sukuk issuance to channel funds from the Middle-East, Malaysia, and Indonesia. For example, recent issuance of a Shari'ah-compliant bond by Osun state in Nigeria and South Africa could start a trend in favour of sukuk, especially if planned sukuk by Senegal.

Developing Islamic Finance in Sub-Saharan Africa

The development of Islamic Finance could increase the depth and breadth of intermediation, extending the reach of the system (e.g. extension of maturities and facilitation of hedging and risk diversification). At the same time, the much larger non-Muslim population could find Islamic financial instruments attractive in broadening the range of available options, particularly for SMEs and micro-credit. Moreover, financial deepening and inclusion could be further enhanced if new instruments are inspired from Islamic finance, but without necessarily being Shari'ah certified. The development of partial risk guarantees, as in Mauritius, could be seen as an example.

In addition, SSA countries could tap into growing Islamic financial markets to meet infrastructure financing needs. By opening doors to Islamic finance, SSA can seek to attract capital from Muslim countries whose savings rates are high and projected to grow. In particular, sukuk financing, which is expanding in other countries, could be a useful tool to finance infrastructure investments.

Lastly, Islamic financing can help develop small and medium enterprises and microfinance activities, given those African households and firms have less access to credit from conventional banks compared to other developing regions. Islamic banks can tap a segment of depositors that do not participate in interest-based banking. They can also promote SMEs' access to credit through expanding acceptable collaterals by extending funds on a participatory basis in which collateral is either not necessary or includes intangible assets.

Through its different forms-windows, full-fledged banking, investment banking, and Insurance-Islamic finance activities ensure appropriate leverage and help limit speculation and moral hazard. It should be noted, however, that they are also subject to constraints and risks, most notably the difficulties and costs involved in supervising and monitoring and the reputational risk implicit in some products that are not properly certified as compliant with Islamic principles.

For countries that want to develop Islamic finance in their jurisdictions, a strategy could contemplate the following steps: launching a public awareness campaign, providing the needed infrastructure (i.e. amending as needed laws and accounting and prudential frameworks), building capacity at the central bank (especially on supervision), and considering the need to set up an appropriate liquidity management framework and introduce adequate monetary operations instruments.

This blogpost is based on the academic study "Islamic Finance in Sub-Saharan Africa: Status and Prospects", prepared by Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu and Etienne B. Yehoue.

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