CHALLENGES OF FINANCIAL SECTOR REFORMS IN AFRICA

Louis KasekendeChief Economist,

African Development Bank

Outline

Introduction The Record of Reform Remaining Challenges Key Factors to Strengthening African

Financial Markets Conclusion

Introduction

Since late 1980s, African countries began to implement financial sector reforms as part of broader market oriented reforms

The objective of the reforms was to build more efficient, robust and deeper financial markets

The financial sector has improved since the implementation of reforms

But the depth and breadth of financial markets in Africa are

inadequate. …….. 5 countries, namely South Africa, Botswana, Egypt, Morocco and Tunisia have relatively developed financial systems.

In 34 countries, the sector is characterised by a low level of development

Financial integration still very low:

African capital markets are the smallest in the world. Africa Share: Stock Market 0.34%; Debt 0.15%; and Banks 0.69%

0%

20%

40%

60%

80%

100%

Stock MarketCapitalisation

DebtSecurities

Bank Assets

Financial and Capital Markets 2002

Africa Asia Latin America EU-15 Japan USA

II. The Record of ReformThe Pre-reform Model: why pressure for reform? At independence the financial sector was

dominated by foreign banks set up to finance colonial trade.

But these were not geared to: finance ambitious post-independence

programs Or service the indigenous sector

Post independence governments established state owned development and financial banks

Pre-Reform Control Model

Governments routinely intervened in financial markets in terms of:

Interest rate determination Directing credit to preferred sectors Market entry and exit Capital adequacy levels Restrictions on external capital transactions Fiscal policy the preferred option, while

monetary policy was largely passive

Pressure for reforms as a result of……. Competing and multiple objectives made

financial regulation complex and difficult Financial repression reduced incentives by

banks to lend to the public In addition as a result of repression and over

reliance on government sources, banks made little effort to mobilize domestic resources

Due to overregulation, banks set up parallel institutions to get round the restrictions (e.g. in Uganda, banks set up parallel deposit taking institutions not subject to central bank supervision and regulation. After liberalization, these wound up.)

Reform Period The late 1980s and 1990s saw African countries

implement financial sector reforms. Three phases identifiable

Phase I: reforms focused on changing policy Liberalization of interest rates and removal of

quantitative restrictions Lifting of barriers to entry and exit Privatization of state-owned banks

But these reforms failed to adequately deal with structural and institutional issues in the sector (Nissanke and Aryeetey, 1998).

Reform Period Second Phase: shifted focus to

strengthening financial infrastructure especially the regulatory frameworks, including the supervisory capacity of the banking system

Central bank independence

Recent phase: putting emphasis on corporate governance issues, including enhancing transparency and accountability improved information and disclosures

requirements, investor education, better accounting and auditing standards that

meet international requirements

Positive outcomes of African Financial reforms In some countries, financial depth has improved

Credit ceilings and directed credit have been eliminated and interest rates liberalized

Banking system improved—stronger balance sheets and capital base (e.g. Nigerian banking sector consolidation has increased the asset base to N5 trillion, up from about N3 trillion before the reforms and has reduced the number of unsound or insolvent banks from 11 in December 2003 to zero as at March 2006.)

Risk management has been enhanced

Growth of capital markets—currently 20 in Africa

Emerging lessons from the Reforms

Liberalization did not reduce the cost of credit or increase availability--high intermediation margins make it difficult to support the growth of the private sector

Removing barriers to entry did not necessarily introduce competition (new banks tended to be small and fragile; oligopolistic behavior of banks)

Liberalization did not close the gap in the provision of services by the formal sector

Government exit from the sector on its own does not necessarily remove patronage: government banks replaced with highly connected private banks.

Lessons from the reforms Cleaning the financial system after decades of

overregulation can be costly Preparing the Uganda Commercial Bank cost

2% of GDP in 1998 Recapitalizing the Central Bank cost 1% of

GDP

When privatizing large state-owned banks, it is advisable to get a strategic partner with substantial financial, technical and managerial resources at their disposal

Success of the reforms hinges on political willingness to take hard decisions

III. Remaining Challenges Financial sector support to the real sector is weak

Corporate lending is still heavily geared towards the short end of the market and few banks engage in long-term lending

Bank balance sheets dominated by short-term deposits

Lack of competition Banking sector is oligopolistic—leads to

inefficient pricing of financial assets (interest spreads usually more than 10%)

Deposit transformation rate remains low Intermediation inefficiency also reduces the

effectiveness of monetary policy on macroeconomic aggregates

Remain Challenges Limited Access to Finance

Fewer than 20% of African adults have bank accounts

Microfinance institutions gradually providing some of the services

However, microfinance institutions have limited outreach and many are not well resourced

Remaining Challenges

Role of the State: either passive or activist Passive role: state limits itself to creating an

enabling environment and institutions.

The state should focus on: macroeconomic stability contractual and information frameworks improving the legal environment for financial

transactions

Remaining Challenges

Active role: direct involvement in addressing market failures Establish specialised intermediaries to provide

finance to areas such as agriculture and the rural economy, micro and small enterprise finance, and low income households

Establish strong and independent market regulators

Pass legislation to protect consumers from predatory practices

IV. Key Factors to Strengthening African Financial Markets Proper sequencing: should be guided by

national characteristics and initial conditions Strengthen rural access to financial services and

develop long-term financing options

Improve financial services technology and infrastructure Promotes efficiency through real time funds

transfer Improves monetary policy management and

bank supervision

IV. Strengthening Financial Markets Increase domestic savings mobilisation to support

investment Restructure and reform pension system Promote long-term financing Develop capital markets

Strengthen corporate governance in financial institutions

Strengthen institutions that support financial reforms Land and company registries Credit reference bureaus, Commercial courts

IV. Strengthening Financial Markets Continue to improve the conduct of monetary

policy Strengthen liquidity management and

forecasting Deepen financial markets Develop comprehensive public debt

management strategies

Conclusion African countries have had successes in their

first and second generation financial sector reforms

But market failures and lingering inefficiencies remain a challenge

African countries face the challenge of deepening financial reforms