Africa Finance Forum Blog

Interest rate caps: The theory and the practice

12.09.2018Aurora Ferrari, Advisor & Oliver Masetti, Economist - World Bank

This blog was originally published on the World Bank Blogs' website.

Ceilings on lending rates remain a widely-used instrument in many EMDEs as well as developed economies. The economic and political rationale for putting ceilings on lending rates is to protect consumers from usury or to make credit cheaper and more accessible. Our recent working paper shows that at least 76 countries around the world, representing more than 80% of global GDP and global financial assets, impose some restrictions on lending rates. These countries are not clustered in specific regions or income groups, but spread across all geographic and income dimensions. However, interest rate caps in high income countries are mostly introduced to protect consumers from usury, while in low income countries they are more commonly introduced to make credit cheaper and more accessible. In Sub-Saharan Africa (SSA) interest rate caps are used by at least 17 countries. This includes upper middle-income countries such as South Africa, lower middle income countries such as Kenya, as well as low income countries such as Chad and Senegal.

Interest rate caps are not static, but are an actively used policy tool. Since 2011, we find at least 30 instances when either new interest rate caps have been introduced or existing restrictions have been tightened. Over 75% of those changes occurred in low- or lower-middle-income countries. In SSA, new caps were implemented in Kenya and existing caps tightened in WAEMU. This outweighs the five instances globally, including Zambia, when restrictions have been removed or eased and indicates that countries increasingly limit the maximum level of lending rates.

A taxonomy of interest rate caps

Interest rate caps come in many different forms. Restrictions used across countries vary substantially regarding what they cover and how they work. An innovative taxonomy presented in this paper classifies interest rate caps according to the following features:

•    Scope. A primary form of variation is the type of credit instrument/ institution and/or borrower they apply to. Caps can affect only a narrowly defined segment of the market (e.g. payday loans, credit cards, mortgages), cover loans by certain institutions (e.g. MFIs or credit unions) or cover all types of credit operations in the economy. WAEMU for example has a broad interest rate cap, while Nigeria applies a narrow cap that only affects mortgage rates.

•    Number of ceilings. Countries use either a single blanket cap for all transactions or multiple caps based on the type of the loan and/or socio-economic characteristics of the borrower. South Africa for example has multiple caps, while Kenya has a single ceiling.

•    Type. The level of the cap can be either defined as a fixed, absolute cap or as a relative cap that varies based on the level of a benchmark interest rate. An example for an absolute cap is the WAEMU, where the cap is set at a fixed 15 percent for banks and 24 percent for MFIs (and other credit institutions). In contrast, Kenya uses a relative cap set at 4 percentage points above the central bank’s rate.

•    Methodology. The level of the relative cap can be either defined as a fixed spread over the benchmark, as in Kenya, or as a multiple of the benchmark rate.

•    Benchmark. Most countries using a relative cap link it to the level of an average market rate, for example, the average lending rate over the past six-months. Alternatively, the ceiling can be defined as a function of the central bank’s policy rate. In Zambia, like in Kenya, the benchmark was the central bank rate, while for CEMAC it was the average market rate.

•    Binding. Independently of the type of benchmark used, caps can be binding or non-binding, i.e. they are below or above market rates. In countries where the primary aim is to prevent usury the ceilings are usually fixed at levels that affect only extreme pricing but leave the core market to operate with minimal implications. In contrast, if interest rate caps are used as a policy tool to achieve certain socio-economic goals, such as lower overall cost of credit, ceilings are set at binding levels intended to influence the market outcome. The caps in Kenya and the one used in Zambia are examples of binding caps, which were set at levels below prevailing market rates. In contrast, the various caps in South Africa are set at high levels.

•    Fees. Some interest rate caps also explicitly regulate non-interest fees and commissions of the loan. This is either done by setting separate limits on non-interest costs or by defining the interest cap in terms of an annual effective rate (APR) that includes all fees and charges. The first approach is taken by the South African Reserve Bank, which publishes a comprehensive list of maximum fees applicable to different types of credit in addition to the respective interest rate caps. 

This taxonomy is illustrated in the figure below:

Effects of interest rate caps

Establishing the causal effects of interest rate caps is challenging due to the heterogeneity of caps used and endogeneity concerns, but economic theory points to several possible side effects. Country case studies on Kenya, Zambia, Cambodia, the West African Economic and Monetary Union (WAEMU), India, and the United Kingdom show that effects and side-effects depend on the type and specification of the cap.

•    Caps set at high levels do not seem to affect the market and can help limit predatory practices by formal lenders. Non-binding caps, i.e. caps set well above market rates, affect only extreme pricing with little impact on the overall market. If interest rate caps include regulations on non-interest fees and the non-regulated lending market is limited, then caps are a potential way to remove predatory lenders in the formal sector.

•    The effectiveness of caps is often undercut by the use of non-interest fees and commissions. The increased use of non-interest charges often reduces price transparency and makes it more complicated for borrowers, especially those with limited financial literacy, to assess the overall costs of the loan.

•    Binding caps set well below market levels can reduce overall credit supply. The extent of the decline depends on the scope of the restrictions. Whereas narrow caps affect primarily a clearly defined market segment, broad restrictions can reduce overall credit supply in the economy. Blanket caps further affect the distribution of credit as they result in a particularly large decline of unsecured and small loans, as well as in credit to SMEs and riskier sectors. Average loan size increases, suggesting a reallocation from small to large borrowers, in many cases to the government.

In light of the possible unintended consequences of interest caps, alternatives and complementary measures to interest rate caps should also be considered. These include measures to foster competition, reduce risk perception, overhead costs, and cost of funds. Consumer protection and financial literacy measures are also important measures, especially if interest rates are meant to protect consumers from usury rates.

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About the Authors

Aurora Ferrari is currently the Adviser to the FCI Senior Director for financial sector issues. Prior she was the manager for Financial Stability, Bank Regulation and Supervision unit of the World Bank (WB). In this capacity she oversaw the WB work in these areas, managed the FSAP program, coordinated the WB participation in Basel and represented the WB at the Financial Stability Board. Before then, Aurora was the manager responsible for financial sector policy advice and programs in Europe and North Africa, which focused particularly on crisis management, bank resolution, and state owned banks. Before joining the WB, Aurora worked at the EBRD in the Financial Institutions Group focusing on investments in banks.

Oliver Masetti is an economist (Young Professional) in the World Bank’s Financial Stability Team. He joined the World Bank in August 2016 and worked for the first year in the Office of the Chief Economist. Previously, he was an economist at Deutsche Bank in Frankfurt covering financial and macroeconomic developments for countries in Sub-Saharan Africa and the MENA region. Oliver holds a PhD in economics from Goethe University Frankfurt and a Master’s degree from St. Gallen University, Switzerland. He was a visiting student at Bocconi University and the Stockholm School of Economics.

Leveraging African Pension Funds to Fill Africa's Infrastructure Gap

03.09.2018Arnaud Floris, Financial Sector Advisor & Yves Kra, Research Officer - MFW4A

This blog benefited from the comments of the MFW4A Coordinator, David Ashiagbor.

New figures from the African Development Bank estimates that Africa needs to invest between US$130 and 170 billion in infrastructure annually, with a funding gap of $68—108 billion1. These are much higher than previous estimates of $93 billion in investment needs and a $31 billion financing gap. At the same time, financing for Africa’s infrastructure has declined by 25%, from a high of $83.3 billion in 2013 to $62.5 billion2 in 2016, according to the Infrastructure Consortium for Africa (ICA).

African governments, western donors, and other bilaterals/multilaterals together provide over 75% of funding for the continent’s infrastructure today. Pressure on public budgets, both domestic and foreign, mean that these alone cannot fund the continent increased needs, as evidenced by the decline in funding (see chart and table). Global attention has therefore turned to how the private sector can contribute to funding Africa’s infrastructure needs. In this context, there is increased interest in the role of Africa’s pension funds in funding the continent’s investment needs.

Source: "Infrastructure financing Trends in Africa - 2016" (ICA)

Economic growth, an emerging middle class, and pension reforms have brought more people into the social security net and have contributed to the growth in pension fund assets under management (AuM), across the continent. Price Waterhouse Coopers (PwC) estimates AuM in 12 African markets will rise to around USD 1.1 trillion by 2020, from a total of USD 293 billion in 20084.  Hard figures are difficult to come by, but it is estimated that less than 1% of AuM across the continent is invested in infrastructure. Why is this and how can African governments, institutional investors, and DFIs work together to leverage Africa’s growing long term savings to fund its investment needs?

For African pension capital to be a viable source of funding for infrastructure, the pension funds need to have the ability and the willingness to invest in the asset class. Their ability to invest is affected by issues like regulation (Is the pension fund allowed to invest in alternative assets? If so, under what conditions and to what extent?), their existing assets under management, as well as their understanding of the sector. The willingness of these same pension funds to invest in infrastructure is affected by their understanding and evaluation of the risks, their assessment of how infrastructure fits within their investment policy and strategy, and their ability to identify projects they are willing to back.

Regulation is often cited as the main stumbling block to investment in infrastructure by African pension funds. However, reforms in key markets are creating an enabling environment for local institutional investors to participate in infrastructure. Nigeria allows pension fund managers to invest up to 5% of AuM in infrastructure funds and 15% in corporate infrastructure bonds5. However, as of March 2018, only 0.08% of AuM was invested in infrastructure bonds and 0.01% in infrastructure funds, according to the National Pensions Commission (PenCom)6.

Some commentators argue that the low levels of investment in these asset classes reflect regulatory barriers such as a ban on direct equity stakes and limitations on cross-border investments. In their view, regulators should be encouraging pension funds to use alternative assets like infrastructure and private equity as a risk diversification tool, and that these limitations, especially with respect to cross-border investments, achieve precisely the opposite effect. Regulators respond that their first duty is to protect the pensions of their fellow citizens. In that context, it would be unwise to give pension funds unrestricted access to an asset classes which neither they, nor the regulators, are familiar with. One only has to look to the origins of the global financial crisis to understand the potential damage which cause.

To invest in infrastructure successfully, African pension funds need the resources to do so. With AuM in countries like Nigeria growing at close to 30% per annum, and given that less than 5% of the population of sub-Saharan Africa is covered by the pension plans, there is obvious scope for significant growth. The global industry figures hide wide variations across and within countries. Industry fragmentation is a major issue in many countries, with assets split across dozens of small pension funds, meaning that they can only make minimal investments, which can be below the minimum ticket size of many infrastructure projects.

Unlocking the potential of African pension funds to finance infrastructure also means addressing factors that influence their willingness to invest in the asset class. First among these is the lack of awareness about the ‘infrastructure asset class’ across the continent. Even in South Africa, with its sophisticated financial markets, few pension funds have experience of investing in infrastructure. Pension funds, regulators, and other stakeholders must be empowered with the right information which will enable them to evaluate if and how infrastructure fits within their investment strategies and objectives.

Secondly, the scarcity of investable assets and the corresponding dearth of appropriate vehicles through which to invest must be addressed. This is a familiar subject for many commentators. However, until recently, there has been little effort to understand the specific risk appetite, regulatory regime, and return expectations of African pension funds. The assumption has been that these are the same as for other classes of investors. The result is that many projects presented to African pension funds today are not investable from their point of view. In short, the approach needs to shift from one of product placement to one of designing investment solutions for African pension funds.

Enabling actions must address both the supply and demand sides of pension fund investment in infrastructure. Potential solutions include targeted interventions in the development of investable infrastructure projects and special purpose vehicles, risk-sharing mechanisms, and more traditional co-investment opportunities through investment platforms. Overall, fostering an exchange of knowledge and a sharing of experiences among industry stakeholders—notably, pension funds, regulators, and asset managers—is key to unlocking institutional capital for infrastructure finance in Africa from both domestic and international investors.

With the appropriate regulation, governance and internal capacity to assess and manage the risks associated with investment in infrastructure, there is no reason why African pension funds cannot take on a greater role in financing the continent’s infrastructure transformation in the medium to long term.

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1  African Economic Outlook 2018, African Development Bank. www.afdb.org/fileadmin/uploads/afdb/Documents/Publications/African_Economic_Outlook_2018_-_EN.pdf 
2  Infrastructure Financing Trends in Africa 2016, ICA. http://www.icafrica.org/fileadmin/documents/IFT_2016/Infrastructure_Financing_Trends_2016.pdf 
3  ICA members include among others G8 countries, African Development Bank, Development Bank of Southern Africa, World Bank, European Commission and European Investment Bank.
4  Source: Africa Asset Management 2020 -­‐ Report by PwC examining the asset management industry across 12 African countries (Algeria, Angola, Botswana, Egypt, Ghana, Kenya, Mauritius, Morocco, Namibia, Nigeria, South Africa, Tunisia). http://www.amafrica2020.com/amafrica2020/docs/am-africa-2020.pdf 
5  PenCom Regulation on Investment of Pension Assets, 17 December 2012.
6  PenCom Monthly Report March 2018. https://www.pencom.gov.ng/wp-content/uploads/2018/05/Summary-of-Pension-Fund-Asset-RSA-Registration-as-at-31-March-2018.pdf 

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About the authors

Arnaud Floris is a Financial Sector Development Advisor with the Making Finance Work for Africa (MFW4A) Partnership. He holds a wide range of working experiences in resource mobilization, general management and strategic development roles within development finance and private sector organizations across Europe and Africa. Before joining MFW4A, Arnaud worked within the resources mobilization and allocation unit of the African Development Bank, where he was a lead team member of the African Development Fund's Performance-Based Allocation process, involving over 100 stakeholders, 54 beneficiary countries, and a three-year budget of 7.5 billion Dollars. 

Yves Kra  is an Associate Research Officer in the Knowledge Management Team of the MFW4A Partnership. Among other daily tasks, he conducts assessments of African national financial sectors and drafts corresponding reports. Moreover, Yves conducts on-demand, bespoke research for the MFW4A Secretariat and its partner institutions, most notably the African Development Bank, European Investment Bank, and the Agence française de développement (AFD). Yves holds a Ph.D. from Paris XIII University, which he defended in 2017 as part of a research project on the complementarity between banks and microfinance institutions in WAEMU (West African Economic and Monetary Union). His current research interests include development finance, microfinance, banking, and applied econometrics to developing countries.

2018 In Review: A Message from the Partnership’s Coordinator

30.07.2018David Ashiagbor

Dear Readers,

As we approach the August break, I am pleased to share with you an update on our activities in the first half of this year and the details of some our initiatives planned for the final quarter of 2018.

Knowledge management is a cornerstone of MFW4A's mandate and mission. We have continued to strengthen our profile as an authoritative source of information on financial sector development in Africa. Our website enjoyed both growing traffic and greater engagement by its visitors-a 5.4% increase in website visitors was recorded, while the number of sessions per user grew by 8.3%. We are in the process of revamping the website, and expect to launch a new look, fresher more accessible version with increased multimedia capabilities in September. Our Webinar series continued with sessions on subjects including digital finance and capital markets, as well a series on Leveraging African Pension Funds for Housing Finance in Africa, in partnership with the Centre for Affordable Housing Finance (CAHF).

We also partnered with CAHF, the African Union for Housing Finance (AUHF), the International Finance Corporation (IFC), and the Caisse Regionale de Refinancement Hypothécaire de l'UEMOA (CRRH-UEMOA) to organise a workshop on 'Mortgage Product Design and Portfolio Management' in Abidjan in February 2018. The workshop brought together over 40 executives of state agencies and commercial banks from 16 African countries to explore the opportunities and challenges related to building viable and sustainable housing finance operations in Africa.

MFW4A also launched our Trade Finance Initiative (TFI), in collaboration with the AfDB and with funding from BMZ and GIZ. The initiative started with a webinar, entitled 'Overcoming Challenges of Trade Finance in Africa,' on 21 March 2018. The TFI aims to improve the understanding of the trade finance market in Africa, promote regulatory compliance, and to build the capacity of local banks introduce sophisticated products and grow their trade finance business, particularly with SMEs.  Other activities planned under the TFI, include policy workshops and capacity building events later this year.

In long term finance, the Secretariat is supporting a consortium of local pension funds who are looking to invest in infrastructure with capacity building. In keeping with the concerns raised by the Consortium members, MFW4A's capacity building will focus on PPPs and infrastructure investment. The first workshop is scheduled for Nairobi in early September. These interventions align with the Partnership's commitment to supporting the mobilisation of domestic savings for long term investment in Africa, a work stream which is also supporting the Africa Investment Forum (AIF), scheduled to take place on 7-9 November in Johannesburg, South Africa.   

Also in September, we look forward to hosting the Francophone Africa Pension Funds Roundtable in Abidjan, in collaboration with FINACTU, a strategic consulting firm specializing in African development,   and CIPRES, the Inter-African Conference of Social Welfare. The Roundtable aims to develop a common understanding of the issues and challenges facing pension funds in francophone Africa, in much the same way as the Secretariat has done for key anglophone markets.  

MFW4A will launch a series of Regional Financial Sector Policy Dialogues, starting with West Africa in September. The event's aim is to take stock of current financial sector reforms in West Africa in order to identify priority actions for the coherent and robust development of the financial sector, with the final goal of informing national and DFI FSD strategies.

Finally, we will host the MFW4A Annual General Assembly (AGA) in Abidjan on 5-6 December. This flagship event will provide us with the opportunity to showcase the Partnership's achievements in the preceding period, as well as our plans and programmes going forward. It is also a platform to engage with you, our stakeholders, so please save the date.

We will of course be providing further details on all these events and much more in the coming months. In the meantime, it remains for me to wish you a restful summer and thank you for all your support. Your newsletter will return on 4 September.

African and Global FDI Inflows Weaken in 2017

09.07.2018Amy Copley, Research Analyst & Project Coordinator, Brookings Institution

This blog was originally published on The Brookings Institution website.

According to United Nations Conference on Trade and Development’s (UNCTAD) latest World Investment Report, from 2016 to 2017, global foreign direct investment (FDI) flows decreased by 23 percent from $1.87 trillion to $1.43 trillion—despite an increase in global gross domestic product (GDP) growth and trade during this time.

The report indicates that a decrease in cross-border mergers and acquisitions (M&As) from 2016 to 2017 contributed significantly to the decline in overall FDI. However, the relative decline in M&As in 2017 was not unexpected, considering that 2016 was characterized by several one-off megadeals of over $30 billion—including foreign acquisitions of U.K.-based companies SABMiller, BG Group, and ARM, as well as U.S.-based firms Allergan PLC and Baxalta Inc., among others.

African FDI inflows comprised 2.9 percent of global FDI inflows in 2017, compared to the 49.8 percent share for developed economies, 33.3 percent share for developing Asia, and 10.6 percent share for Latin America and the Caribbean. In line with the decline in global FDI flows, FDI flows to Africa similarly slumped by 21.5 percent from $53 billion in 2016 to $42 billion in 2017. The report shows that African FDI inflows have continued to contract since 2015 due in large part to the lingering macroeconomic effects of the 2014-2016 oil price slump, with flows to commodity-exporting countries declining more so than to diversified economies (Figure 1).

Figure 1. FDI inflows and outflows, 2011-2017, by region


Source: UNCTAD, World Investment Report, 2018

Africa’s top destinations for FDI inflows in 2017 were Egypt ($7.4 billion), Ethiopia ($3.6 billion), Nigeria ($3.5 billion), Ghana ($3.3 billion), and Morocco ($2.7 billion). It is worth noting that, of these top FDI destination economies, only Morocco experienced an increase in FDI from 2016 to 2017 (of 22.9 percent) while the rest of these economies saw declines. The influx of FDI to Morocco stems from a series of deals related the country’s auto industry and new car technologies, as well as Chinese investment in the banking sector. Meanwhile, the top countries from which FDI flows originated were South Africa ($7.4 billion), Angola ($1.6 billion), Nigeria ($1.3 billion), Morocco ($1.0 billion), and Togo ($0.3 billion). South Africa led the region in FDI outflows as South African retailers and Standard Bank expanded into Namibia, and the South African “Africa Private Equity Fund” of Investec made several intra-African acquisitions. According to Figure 2, the region’s top investors in 2016, in terms of FDI stock in African countries, were the U.S. ($57 billion), the U.K. ($55 billion), France ($49 billion), China ($40 billion), and South Africa ($24 billion).

Figure 2. FDI flows, top 5 African host economies, 2017

Announced greenfield investment in Africa amounted to $85 billion in 2017, down from $94 billion in 2016. Greenfield FDI projects in the services sector received the most investment at nearly $54 billion (particularly in electricity, gas, and water, which accounted for $37 billion in investment), followed by the manufacturing sector with $21 billion, and the primary sector with almost $11 billion.

Moving forward, the report suggests that African FDI inflows may strengthen by 20 percent in 2018—to $50 billion—as commodity-exporting economies continue to recover from the commodity price slump. Without government support to promote economic diversification in these economies, however, commodity dependence in the region will cause FDI to remain cyclical and trapped in “commodity enclaves,” where it has fewer positive spillovers in terms of technology transfer and promoting linkages with domestic suppliers, according to the report. On another note, the report argues that as the implementation of the African Continental Free Trade Area (AfCFTA) agreement progresses, market-seeking FDI is also expected to pick up in the region, barring unforeseen downturns in the global policy environment.

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About the Author

Amy Copley is a Research Analyst and Project Coordinator with the Brookings Institution’s Africa Growth Initiative based in Washington D.C. She holds a Master’s degree in International Development and Humanitarian Emergencies from the London School of Economics and Political Science, and Bachelor’s degrees in International Politics and Applied French from Penn State University. Her research interests include agricultural development, food security, and structural transformation in Africa, as well as complex emergencies and the nexus of conflict and development.

Exploring the implications of Basel III Liquidity Standards for Africa

25.06.2018Alassane Diabaté, PhD Researcher, University of Limoges

This blog was originally published in French on a Think-Tank website (L'Afrique des Idées).

In 2007, the world was hit by the most severe economic crisis since the Great Depression of 1929. The financial crisis exposed several weaknesses in the global economy, and particularly in the liquidity management of banks [1]. In order to strengthen and ensure a sound financial system, the Basel Committee on Banking Supervision (BCBS) established two new liquidity standards, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR)  in 2010, under the Basel III agreements. These ratios have gradually come into effect since 2015. The NSFR will come into effect in 2018 and will be followed by the Liquidity Coverage Ratio in 2019.

Unfortunately, most African countries have not yet adopted these liquidity standards—according to a 2015 FinAfrique report, the West Africa Economic and Monetary Union (WAEMU) and members of the Central African Economic and Monetary Community (CEMAC) are still migrating to Basel II, while Nigeria is already in compliance with Basel II standards. Despite the slow progress, these countries nevertheless aspire to applying Basel III within their domestic financial markets. What might be the impact of these liquidity standards on African economies, and on their respective financial sectors?

The Liquidity Coverage Ratio (LCR)

The LCR is a stress test which aims to anticipate and avoid market-wide shocks. Banks which adhere to the liquidity coverage ratio are guaranteed to have the necessary assets to ride out any short-term liquidity disruptions. To calculate the ratio, the stock of high-quality liquid assets is divided by the net outflows over the next 30 calendar days. Highly liquid assets correspond to level 1 (cash, reserves at the central bank level, etc.) and level 2 assets (covered bonds rated AA- or higher and assets with 20% risk weighting).

The Net Stable Funding Ratio (NSFR)

By adhering to the Net Stable Funding Ratio, banks become more resilient and are better-prepared for liquidity risks over the long-term. It is calculated by dividing the amount of available stable funding by the amount of stable funding required. It can then be defined as the proportion of long-term assets [2] financed by long-term or stable financing [3]. The stable funding available relates to the share of capital and liabilities maturing in excess of one year. The required stable financing corresponds to the various assets held by the bank concerned, including its off-balance sheet exposure [4]. As a result, using the NSFR, regulators can encourage banks to maintain a stable financing profile in relation to the composition of their assets and off-balance sheet activities. By applying the NSFR, banks will use stable sources of financing in order to reduce the likelihood of disruption to the bank's regular sources of liquidity, which is expected to reduce the probability of bankruptcy.It also aims to reduce the excessive use of short-term wholesale financing [5]. Banks can indeed be encouraged to expand their balance sheets very quickly. For this, they can rely on cheap short-term wholesale financing. And yet, a rapid increase in the size of the balance sheet may weaken their ability to respond to liquidity shocks.

The limits of Basel III liquidity regulation

Although the new regulations of the Basel III framework seem to eliminate much of the bank liquidity risk and represent a significant advance in the management of liquidity risk, their application can generate new problems. The LCR prioritizes low-risk assets such as government bonds. In order to meet this regulatory requirement, banks may prefer to lend to governments, and they therefore have less incentive to lend to investors. This will reduce private investment. This decline in private investment may lead to a slowdown in economic activity if it is not offset by increased public investment, such as through bank loans. Moreover, we have all witnessed the 2011 sovereign debt crisis in the euro area—this crisis has shown that the risk of default by a state may exist, and therefore government bonds may indeed be risky and illiquid.

The Net Stable Funding Ratio (NSFR) is also flawed. The main limitation of this ratio is that it goes against one of the main intrinsic functions of banks: Maturity transformation. Banks transform short-term funds, such as savings deposits, into long-term loans, such as mortgages. Thus, with a view to reducing the maturity mismatch—all while requiring banks to finance a large portion of long-term assets with stable funds—the long-term structural liquidity ratio could push banks to offer less credit and non-optimal resource allocation. On the one hand, an inefficient allocation of resources will negatively impact the performance of banks and, on the other hand, the narrowing of credit activity would lead to a slowdown in economic activity.

Basel III liquidity risk regulation: danger or solution for Africa?

Banks are also known to be the lungs of economies. They fund savings mainly through their loans, which they give to economic agents. They ration loans and fix the remuneration of these loans (debit interest rate) according to the risk profile of potential borrowers. The payment of the loans constitutes the risk premium taken by the bank. Thus, the higher the risk, the higher the interest rate will be. Banks also provide credit according to the economic environment. They will be more incentivized to produce loans at relatively low rates when they have confidence in the economic environment.

Generally in Africa, banks can often incur risks when faced with potential borrowers because of their opacity. This opacity is supported by the non-negligible weight of the informal sector (25% to 65% of GDP, according to the IMF). The lack of information on loan applicants is an essential element that reduces the lending activity of banks and especially that requires high interest rates. In addition, there are no important structures that can increase the incentive for banks to lend. In developed countries, for example, there are structures that support the unemployed (such as employment in France). These structures guarantee an income stream for workers in the event of job loss, thus reducing the risk of default when these workers wish to have a loan. The absence of such structures in most of Africa, does not facilitate the establishment of credits from banks.

While this problem could be alleviated with the introduction of insurance, the insurance premium would make the total cost of loans larger. In addition, for most loans granted, the bank requires life insurance that will guarantee repayment of the loan in the event of the death of the borrower. In Africa, life expectancy is on average 60 years, whereas in France, it is 82 years, according to the French public information radio France Info. In a 2016 WHO press release, twenty-two countries in sub-Saharan Africa have a life expectancy of less than 60 years. We end up with much higher insurance premiums in Africa, which means that the loan costs are significant enough to support the potential borrower. The importance of these costs obviously has a negative impact on loan demand. The bank rate is also quite low in Africa. It is 10% in sub-Saharan Africa, it is between 7.4 and 8% in the WAEMU zone, and it is close to 40% in Morocco, against 99% in France, according to the Africa24 news channel.

As a result, banks collect fewer deposits because of hoarding of households. And yet to make the loans, the bank uses essentially its deposits. Thus, the low collection of deposits discourages the setting up of loans and encourages more rationing credits. Finally, the risk of political instability in some countries does not also favor the establishment of loans because it deteriorates the confidence of bankers.

Because of these aspects, African banks limit their lending activities and demand high interest rates.

As mentioned above, the new Basel III liquidity requirements may encourage banks to lend less. Thus their application in Africa, a continent already suffering from lack of funding, could be harmful for the performance of African banks and especially for African economies. It would be interesting to think of a regulation according to the level of development of the countries.

Sources and footnotes

Basel Committee on Banking Supervision, 2010, Basel III: International framework for liquidity risk measurement, standards and monitoring.

Idrissa Coulibaly, 2015, L’impact des réglementations internationales BÂLE I, II & III sur le système bancaire africain (The Impact of Basel I, II & III international standards on the African banking System), FinAfrique

[1] The term liquidity has a large scope. Three basic definitions are possible: (i) the liquidity of a financial security defined as the ease of selling it without losing value; (ii) the liquidity of the market defined as the possibility of trading on this market a large quantity of securities without influencing their prices; (iii) the liquidity of financing for a firm that can be defined as the ability to honor its obligations at time over a given period.

[2] These are assets that can not be liquid or used for at least one year.

[3] The sources of long-term financing are resources spread over more than one year (capital, long-term debts, etc.).

[4] The off-balance sheet activities of a bank are all activities that are not recorded in its balance sheet. These include credit commitments for example.

[5] In addition to the traditional source of financing used by banks (deposits), they also use wholesale financing. This source of financing mainly corresponds to US banks, federal funds, foreign deposits and brokered deposits. These types of financing are most often short-term. As a result, a bank that is highly dependent on these types of financing can easily face a liquidity problem if it is perceived as risky or poorly capitalized.

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About the Author

Alassane Diabaté is a PhD candidate in Banking Economics at the University of Limoges (France) and conducts his research in the Laboratory of Economic Analysis and Prospects (LAPE). His key interests are about the banking system (regulation, capital structures, risks and banking strategies). Alassane also teaches at the same university in macroeconomics, monetary macroeconomics and microeconomics.

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Interest rate caps: The theory and the practiceAurora Ferrari, Advisor & Oliver Masetti, Economist - World Bank
Leveraging African Pension Funds to Fill Africa's...Arnaud Floris, Financial Sector Advisor & Yves Kra, Research Officer - MFW4A

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