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The global financial crisis has highlighted the vulnerability of financial systems and stressed the need for improving the management of financial vulnerability. The financial stability issue in low-income countries (LICs henceforth) has received less attention in recent years, insofar as they have been less impacted by the global financial crisis than emerging economies. However, a better understanding of financial fragility mechanisms in LICs is crucial. The experience of LICs shows that they could suffer sharp increases in non-performing loans and banking crises, and that the cost of banking crises is high, even if the banking sector is small.
In a recent paper, we investigate the determinants of financial fragility in advanced and developing countries, focusing on the interaction between credit booms and credit information sharing systems. A large number of studies have shown that excessive credit booms are one of the main drivers of financial crises. The development of credit information sharing (CIS) institutions may attenuate the negative effect of credit booms and/or limit the occurrence of such booms.
First, CIS can mitigate the negative effect of credit booms. A rapid growth of credits can weaken the quality of credit screening. During credit booms, credit officers cannot devote sufficient time to correctly screen new projects and bad projects have a higher probability of being financed. The presence of efficient CIS institutions could attenuate the negative effect of credit booms with screening. In addition, credit booms often fuel a rapid rise in asset prices (real estate and equity bubbles). Since assets may be used as collateral, the price rise will itself help an acceleration of credit growth ("financial accelerator") and reinforce the deterioration of screening. The presence of information sharing mechanisms may allow banks to diversify their portfolio. This diversification can limit the increase of asset prices induced by rapid credit growth, and therefore limit the detrimental impact of such episodes.
Second, CIS might affect the occurrence of credit booms, even if its effect is theoretically unknown. On the one hand, information sharing may curb credit growth by avoiding some customers borrowing from several banks. On the other hand, a reduction in the information asymmetries across banks may lead to an easing of lending standards and, in turn, an increase in the volume of lending (lending boom). Mechanisms through which CIS alleviates the detrimental and occurrence of credit booms can differ between developing countries and industrialized economies.
In order to identify the impact of information sharing and its transmission channel, we built a dataset combining a bank-level and country-level database. The sample included 159 countries with 79 developing countries and 80 emerging and developed countries over the period 2008-2014. To study whether developing countries differ from other countries, two groups of countries were distinguished: countries with a GNI per capita below US$ 4,125 in 2014 (n=79, called developing countries) and countries with a GNI per capita exceeding US$ 4,125 (n=80, called developed and emerging countries). Financial fragility was assessed by scrutinizing annual changes in the ratio of NPL to total loans. Episodes of financial fragility were identified every time this ratio jumped by at least 3%. This measure enabled capturing all episodes of financial distress and not only the extreme ones (banking crisis). The development of CIS was assessed by the depth index and the coverage of CIS. Both were extracted from Doing Business.
Estimations confirmed findings from other papers by highlighting the stabilizing impact of CIS. The paper also documented that this result held for both less developed countries (GNI per capita below US$ 4,125) and other countries (advanced and emerging). In a second step, the complex relationships between CIS, credit booms and financial fragility were analyzed. Econometric estimations pointed out several important results: (i) information sharing development had a direct effect on financial stability, even when the impact of credit booms was taken into account; (ii) the higher the scope of information collected, the lower the likelihood to observe a credit boom (but the coverage of CIS did not matter); this effect was smaller and less significant in developing countries; (iii) CIS mitigated the detrimental effect of credit boom but this result held only for advanced and emerging countries; and (iv) credit booms were strong predictors of financial vulnerability, especially in advanced and emerging countries.
These results have several policy implications. First, credit growth is a key variable for macro-prudential policies in low and middle income countries. Second, current efforts to develop CIS schemes should be strengthened, since the latter allow for credit expansion without excessive increase in the overall credit risk. Third, CIS has little impact on credit booms in developing countries, which justifies the extension of other tools - such as macro-prudential policies - to prevent excessive credit growth. Finally, extending the coverage of information sharing systems is not enough, since depth of information sharing is more efficient in avoiding credit booms.
About the Authors
Florian Léon is currently a postdoctoral research fellow at CREA (University of Luxembourg). Samuel Guérineau is an Associate Professor at the Université d'Auvergne.
This work is part of a research project which received financial support from the DFID-ESRC Growth Research Programme (Grant No. ES/L012022/1). Other project's contributions focus on the implications of capital flows (FDI, aid, remittances) on long-term growth. All contributions are available and can be commented on the blog dedicated to the project.
What we learned from the Conference on Financial Sector Development in African States Facing Fragile Situations? - Part 119.07.2016,
Last month, leaders from the public and private sectors and development partners gathered in Abidjan to discuss the links between fragility, resilience and financial sector development in Africa. This event, a joint initiative created by the African Development Bank, the Making Finance Work for Africa Partnership (MFW4A), FSD Africa, FIRST Initiative and the Initiative for Risk Mitigation in Africa (IRMA), also provided an opportunity to explore prospects for partnerships, innovative policies and private sector-led solutions to accelerate financial sector development in fragile situations in Africa.
In this first instalment of a six-part series, Amadou Sy, Senior Fellow and Director of the African Growth Initiative, Brookings Institution, looks at some of the major takeaways of the conference.
What is fragility?
Using a "harmonized definition," the African Development Bank (AfDB), the Asian Development Bank, and the World Bank classify states as being fragile when they exhibit poor governance or when they face an unstable security situation. For practical purposes, governance is measured by the quality of policies and institutions (states with a CPIA score less than or equal to 3.2) and insecurity is assessed by the presence of United Nations or regional peace keeping operations (PKO). In sub-Saharan Africa most fragile states are also low-income countries (LICs).
While the focus of the "harmonized definition" is on institutions and insecurity, participants stressed that fragility is a multi-faceted concept. In particular, fragility implies weak state institutions, poor implementation capacity, underdeveloped legal and financial infrastructure as well as low social cohesion and the exclusion of a large share of the population from financial and other services. The nature of fragility is also fluid and fragile states face situations ranging from violent conflicts to post-conflict economic recovery. The sources of fragility go beyond poor governance, low GDP per capita, and conflicts to include vulnerability to commodity shocks and other macroeconomic shocks, and exposure to the risk of pandemics.
The need to broaden the definition of fragility was further explored with reference to a quote from President Ellen Johnson Sirleaf of Liberia "fragility is not a category of states, but a risk inherent in the development process itself". Mr. Sibry Tapsoba, Director of the Transition Support Department of the AfDB argued for a multidimensional approach, which applies a fragility lens to (i) look beyond conflict and violence; (ii) focus on inclusiveness and institutions; (iii) recognize the importance of the private sector; and (iv) recognize the presence of asymmetries in resources, policy, and capacity.
Participants also insisted on the need to go beyond the negative connotation of fragility and recognize instead that fragile states are in transition and present opportunities for human and financial sector development.
What role for financial sector development (FSD) in fragile countries?
Empirical evidence points to the positive role that financial sector development (FSD) can play in fragile countries. There is a positive correlation between financial sector and economic growth, poverty reduction, and inequality reduction. FSD can be a driver of growth through increased job creation and it can help mitigate risks through increased savings, loans, and insurance.
A key finding stressed by Ms. Emiko Todoroki, Senior Financial Sector Specialist at FIRST Initiative is that fragile countries fare worst in all macro and financial metrics, except one: the share of adults with mobile accounts. Digital financial services are offering solutions in fragile states and there is a need to understand better their role.
In the same vein, Ms. Thea Anderson, Director at Mercy Corps argued for the need to focus in on micro issues such as the role of delivery channels, payments infrastructure, insurance, and blended finance (including impact investment), and Islamic finance. As she noted, FSD is relevant even in the more volatile security situations. For instance, refugees and internally displaced persons (IDPs) can be viewed as a market segment and their financial inclusion can be kick-started with the use of functional identification (which also help comply with Know Your Customer (KYC) requirements). Mr. Paul Musoke, Director of Change Management at FSD Africa also highlighted the role of markets and market building in a difficult context. He noted the need to look for scale, sustainability, and systemic change. As markets are dynamic and not predictable, taking a systems approach can be useful. Such an approach includes asking questions such as what factors are going to play a role in the future? Who is going to pay for infrastructure? What level of development should we target?
Lastly, Mr. Cedric Mousset, Lead Financial Sector Specialist, World Bank reminded the audience that governance remains a key dimension of fragility. Weak governance in fragile countries exposes them to a higher risk of non-compliance with regulations such as anti-money laundering and combating the financing of terrorism (AML-CFT) regulation. Improving governance, although it may be a slow process, is needed to support FSD. Measures to support political stability, improve the business and macroeconomic environment, ensure legal security, and build capacity remain important.
You can download all the presentations on the conference website.
You can also view a selection of photos here.
For more information, please contact:
Pierre Valere Nketcha Nana
International Transmission of Shocks via Internal Capital Markets of Multinational Banks: Evidence from South Africa30.11.2015,
It is well documented that global banks contribute to international shock transmission via cross-border lending. Yet, global banking has taken another form over the recent decades with the expansion of banks abroad via branches and subsidiaries. This expansion has especially happened from and to developing and emerging economies, as countries have opened up their banking sector to foreign investors (Claessens and van Horen, 2012).
Multinational banks operate internal capital markets through which they (re-)allocate capital between their headquarters and their different foreign affiliates in response to financial or real economic shocks. In developing countries where interbank and capital markets are underdeveloped and a large part of the population is unbanked, the ability to receive funding through internal capital markets at low cost and in large quantity might present a significant advantage for foreign banks' affiliates. However, as internal funding reallocation can alter the funding position of a bank's affiliate, this may in turn lead to adjustments in foreign affiliates lending in their host market, thus creating another channel of international transmission of shocks (Cetorelli and Goldberg, 2012).
Impact of a financial crisis on capital re-allocation inside banking groups
In a recent study, I explore this issue by using a novel database on banks operating in South Africa, which includes information on internal loans and deposits from and to the banking group.
In exploring the impact of the 1997 East Asian Crisis on capital re-allocation inside banks, I found that that South African affiliates belonging to banking groups with high exposure to East Asian Crisis countries (in terms of total banking assets of the group in crisis countries) experienced a significant drop in their net internal funding position during the crisis, relative to South African affiliates of less exposed groups. The South African foreign affiliates of highly exposed multinational banks both received less internal funding from their group during the East Asian Crisis period than before, and lent more to their group, relative to the affiliates of less exposed groups. This result suggests that parent banks of more exposed groups reallocated capital away from South Africa to support their affiliates in east Asia.
Exploring the link between internal capital funding and domestic lending
Do foreign affiliates that receive internal capital from their group expand their local bank credit? Using an instrumental variable technique, I found that a 10% increase in the outstanding volume of internal funding resulted in a 5.6% increase in the volume of mortgage advances. As such, foreign affiliates do not only use this extra capital to acquire government securities or to invest abroad, as it has been reported in Africa where banks are often highly liquid but lend relatively little domestically (see Beck, Maimbo, Faye and Triki, 2011).They also "pass it on'' to the local economy by expanding their domestic lending.
This study suggests that foreign affiliates have ambiguous effects for the financial stability of the host country. On the one hand, being part of a foreign group reduces the risk of bankruptcy of foreign affiliates by allowing for the reception of internal capital from the group.
On the other hand, internal capital markets are a channel through which financial crises are transmitted from one country to another, when abrupt capital reallocations inside the group take place. However, the strength of this channel will partly depend on the legal structure of the foreign affiliate. Indeed, the organisational form of the foreign affiliate, either as a branch or as a subsidiary will have an impact on the stability of the banking sector and the local supply of credit through the internal capital market channel, as branches are more integrated to their group via this channel than subsidiaries.
A potential policy implication of this research for bank regulators may be that favouring organisation of foreign affiliates as subsidiaries rather than branches, through specific banking regulations, may reduce the potential transmission of foreign crises via internal capital markets. One caveat, however, is that if a banking crisis occurs in the host country, a parent is fully responsible for all losses incurred under a branch structure. Under a subsidiary structure, a parent's obligations are only limited to the value of the invested equity, which makes it more likely to walk away from the operation (Cerrutti et al., 2007; Fiechter et al., 2011). That said, if a foreign affiliate has systemic importance for the health of the banking group, its parent is more likely to support it through transfers of internal liquidity, regardless of its organisational form.
Beck, Thorsten, Samuel Maimbo, Issa Faye, and Thouraya Triki. 2011. Financing Africa: Through the crisis and beyond. Washington DC: World Bank.
Cerutti, Eugenio, Giovanni Dell'Ariccia, and Maria Soledad Martinez Peria. 2007. “How banks go abroad: Branches or subsidiaries?” Journal of Banking and Finance 31 (6):1669-1692.
Cetorelli, Nicola and Linda S. Goldberg. 2012. “Liquidity management of U.S. global banks: Internal capital markets in the great recession.” Journal of International Economics 88 (2):299-311.
Claessens, Stijn and Neeltje Van Horen. 2012. “Foreign Banks: Trends, Impact and Financial Stability.” Working Paper WP/12/10, IMF.
Fiechter, Jonathan, Inci Otker-Robe, Anna Ilyina, Hsu Michael, Andre Santos, and Jay Surti. 2011. “Subsidiaries or Branches: Does One Size Fit All?” IMF Staff Discussion Note SDN/11/0, IMF.
This blog post is based on the MFW4A Working Paper Series "Internal capital market practices of multinational banks: Evidence from South Africa".
Adeline Pelletier is an assistant professor at IE. She was previously a postdoctoral researcher affiliated to the Centre for Economic Performance at the London School of Economics, researching mobile payment services for the unbanked. She obtained her PhD in Business Economics from the London School of Economics in 2014, with a thesis on the performance, corporate financial strategy and organization of multinational banks in Africa. Prior to her doctoral studies she completed a MPhil in Development Studies at the University of Cambridge (2011) and she also holds a MPhil in Economics from Sciences-Po Paris (2006).
The Zambian economy has continued to recover from the effects of the global economic crisis. In 2010, real GDP is estimated to have grown by 7.1 percent from 6.4 percent in 2009, far exceeding the target of 5 percent for 2010. This was largely driven by the continued strength of the agricultural, mining, and construction sectors, and a rebound in the tourism sector.
However, Zambia, like many other sub-Saharan countries, has been grappling with the problem of low domestic savings needed to enhance economic growth and development. Excessive reliance on foreign savings to finance investment is highly unsustainable as evidenced by the decline in Zambia’s foreign private investment inflows to about 7.2% of GDP in 2009 from 16.7% of GDP in 2007, due to the global financial crisis.
Over the long term, greater reliance on domestic resources is critical if Zambia, like other African countries, is to develop more resilient economies. Domestic savings and investment in Zambia, and many other African economies, are low. Investment has thus been financed mainly through foreign savings. One of the reasons for this has obviously been low income levels and a narrow tax base. Another important constraint has been that of low financial intermediation.
However, the potential of savings in rural areas is high and, if captured, could help redress the situation.
The issue of high lending rates has become topical in Zambia. After the liberalisation of the economy in 1991, the Government moved away from financial repression by abandoning the administrative controls on interest rates. This means that lending rates are determined by the forces of demand and supply in the credit market, overcoming the inefficiencies that resulted from financial repression. An important effect of this repression in the credit market was that it limited the supply of credit while at the same time increasing demand when the rates were set below the market equilibrium level. This partly led to credit rationing and thus limited the ability of financial intermediaries to effectively use their roles to contribute to economic growth and development.
In a liberalised financial market environment, the Central Bank contributes to the reduction in lending rates by reducing inflation. The Government also contributes by implementing prudent fiscal policy, thus limiting the crowding out of the private sector by the Government. This should reduce the cost of lending to the private sector.
A key factor that commercial banks take into consideration in determining lending rates is the risk of default arising from the poor credit culture in the economy in general. To help resolve the problem, the Bank of Zambia, through the financial sector development plan, has facilitated the establishment of a credit reference bureau which collects information on borrowers that is used by credit providers. It is hoped that this will lead to a fall in default rates and thus increase intermediation.
The response of commercial banks to the factors outlined above has been slow. Therefore, another avenue taken by the Central Bank to achieve lower rates is the stimulation of competition in the financial system. In this regard, the number of commercial banks registered in Zambia has increased from 13 in 2002 to 18 at end 2010. It is envisaged that as competition in the banking sector increases, banks will be more innovative in attracting savings from the unbanked public, especially in rural areas, and making their operations more cost effective. This will lead to competitive pricing of banking products and services and enhance financial intermediation.
For its part, the Zambian Government has tried to address the problem of low financial intermediation through the implementation of a financial sector development plan. With 67 percent of the population having no access to financial services, effective financial intermediation is inhibited. There are a number of factors that can be attributed to this, including high transaction costs associated with opening bank accounts and low outreach by existing financial institutions, especially in rural areas. As there are very few banks outside urban areas, most people in rural areas have limited access to finance.
In 2011, the Bank of Zambia aims at further reducing inflation to lower levels. The decline in inflation and Government securities yield rates should, in the coming periods, contribute to a decline in banks’ lending rates and thus stimulate borrowing by the private sector. These efforts are expected to be complemented by efforts aimed at enhancing financial inclusion, including financial literacy and improving the supply and outreach of innovative banking and financial services. These efforts will go a long way in improving financial intermediation, which will in turn contribute to sustainable growth in Zambia.
The global financial and economic crisis exerted a serious macroeconomic impact on the economies of sub-Saharan Africa (SSA); average real GDP growth in 2009 fell by more than 4 percentage points compared to the annual average in the five preceding years. Nevertheless, the banking systems in most countries of SSA weathered the crisis without major damage. Unlike many of the advanced countries and some of the emerging markets, SSA avoided a systemic banking crisis. Banking systems in SSA remained both solvent and liquid. Many commentators have attributed this to the lack of integration of SSA banking systems into global financial markets; a somewhat incongruous conclusion given that international banks dominate the banking systems in many SSA economies.
Less attention has been paid to the strength of prudential regulation in SSA and the contribution which this made to maintaining banking system stability on the continent. It is now recognised that weaknesses in prudential regulation in the advanced countries contributed to the financial crisis. Regulators in advanced countries employed “light touch” regulation in which most of the emphasis was placed on capital adequacy requirements which proved vulnerable to “gaming” by banks, enabling them to ramp up leverage and operate with very little equity capital. In several important respects, SSA bank regulators imposed stricter prudential regulation than did their counterparts in advanced countries. I will use the bank regulations in Uganda to illustrate these points but Uganda is not unique in SSA and its regulatory framework is qualitatively similar to that of many other SSA countries.
Many SSA countries impose higher statutory minimum capital requirements than do advanced economies; for example Uganda imposes minimum tier 1 and total capital to risk weighted asset ratios of 8 percent and 12 percent respectively, compared to the Basel minimum of 4 percent and 8 percent respectively which was the standard in advanced economies. In addition, SSA regulations impose much stricter standards in respect of the quality of tier 1 capital; for example, banks in Uganda must deduct all intangible assets when computing tier 1 capital, hence there is little scope for meeting the tier 1 capital requirement other than with paid up equity capital and retained earnings.
In contrast to bank regulations in the advanced countries, SSA countries did not put excessive emphasis on (an arguably flawed) capital adequacy requirement. Although capital adequacy requirements play an important role in bank regulation in SSA, they are complemented by other prudential regulations, in particular restrictions on the composition of banks’ asset portfolios and their business activities which are designed to curb risk taking. Uganda imposes restrictions on large loan concentrations, on the trading activities of banks (such as trading equities) and on foreign exchange exposures. Uganda bank regulations also restrict dividend distributions when a bank’s capital is impaired or close to being impaired. Loan loss provisioning requirements are stricter, with less scope for deducting collateral values (which are often difficult to realise) from the value of non performing loans which must be provisioned for and a requirement for a general provision irrespective of the performing status of the loan. Uganda also imposes a minimum liquidity requirement.
Stricter prudential regulations did not prevent dynamic growth in SSA banking systems in the 2000s, a period in which several SSA countries experienced credit booms. In the five years from 2004 to 2009, bank credit to the private sector in Uganda expanded in real terms at an average annual rate of 20 percent. However stricter prudential regulations did help to ensure that the rapid credit growth did not lead to financial fragility in the banking system and they also ensured that banks business activities remained focused on supplying traditional banking products, such as loans to the private sector, which are the priority for the development of SSA economies, rather than proprietary trading activities.
The Basel Committee on Banking Supervision has drawn up proposals for strengthening bank regulations at the global level which in some respects move the global minimum standards towards the standards already in force in SSA. Minimum tier 1 capital requirements will be raised, banks will not be allowed to count intangible assets towards tier 1 capital (to raise the quality of capital), a capital conservation buffer, a countercyclical capital buffer and a liquidity requirement will be introduced. In the United States, restrictions are being re-imposed on banks’ proprietary trading activities. Bank regulations in SSA are not perfect and will need to be upgraded in the years ahead to meet evolving challenges to financial stability, but it is fair to conclude that the stricter approach taken by bank regulators in SSA, compared to their counterparts in advanced economies, contributed to the resilience of the banking system in the face of the worst global financial crisis in more than half a century. African bank regulators got the basics right.
Dr. Louis A. Kasekende is the Deputy Governor of the Bank of Uganda. He began his five-year term in this position in January 2010. From May 2006 to 2009, he served at the offices of the African Development Bank (AfDB), in Tunis, Tunisia, as Chief Economist.