The African Financial

Development Gap*

Lemma Senbet

University of Maryland and AERC

*Keynote address in honor of Erik Thorbecke, Cornell University, April 2013

BACKGROUND

Background

Africa is Rising

In late 50s into early 60s most African countries were regarded at par or ahead of most developing countries in Asia and Latin America in terms of economic development.

Yet, Africa’s growth performance has long been disappointing, referred to as a tragedy by some commentators.

But changing: Africa growth renaissance

Africa rising!

Africa On the Move

Pre-Crisis Period

In the aggregate, Africa began rising in the wake of the 21st century and had, in fact, experienced, what amounts to growth renaissance

That was before it got caught up in the global crisis.

GDP growth of 5.2% for the three year period (2002-2007) prior to the crisis, outpacing population growth

Inflation was brought under control

Improvement in fiscal discipline

Declining debt burden/increasing capacity for debt service

Increasing foreign investment and remittance flows

Performance not Accidental Payoffs to Reforms

Impressive performance outcomes are payoffs to economic and financial sector reforms – not accidental

Extensive economic and financial sector reforms over the last two decades, including large scale privatization programs as well as measures to empower private initiative, measures for capital market development

Emergence of stock markets in Sub-Saharan Africa as a particularly interesting feature, including a regional market

Resilience and Diversity of African

Economic Performance

Overall, African economies have been resilient to the global crisis

The effect of the crisis was, nonetheless, significant

The growth dropped to 2.5% from a three-year pre-crisis average of 6% [Channel for crisis transmission]

However, no bailouts, no large bank failures, no large company failures

Growth has resumed, even accelerating

For years, oil and other commodities have been drivers of growth, but currently non-oil producing countries are growing at a similar rate

Now seven African countries are among the fastest growing in the world

SSA is growing faster than Asia, except China and India

Challenge: African Financial

Development Gap

Growing evidence for the role of finance in economic development

Yet, most countries in Africa face a severe financial development gap relative to not only the advance economies but other developing economies.

The pre-crisis 2007 financial development indicators are telling in that respect

African Financial Development Gap

Banking depth: The liquid liabilities of financial sectors averaged about 30 percent of GDP for Sub-Saharan Africa

The indicator averaged 50% or more for Latin America, East Asia, South Asia, the Middle East and North Africa

Banking intermediation: Things even worse on this score: the pre-crisis 2007 average private date credit provision scaled by GDP was half the size for other developing countries

But, why do we care about this low level of financial development?

Financial Sector Development and

Economic Development

A financial system should be judged ultimately on its role in economic development.

The available empirical evidence is that well-functioning financial systems, along with well-designed institutions and regulatory systems, foster economic development (e.g., Levine and

Zervos, 1998).

Some evidence in the context of Africa as well (e.g., Yartey and Adjasi, 2007; follow-up by Senbet and

Otchere, 2008)

Implications for Africa

The empirically supported positive linkage between financial sector development and economic development provides a strong case for the development of a well-functioning financial sector in Africa.

The implication for Africa: Suggests a linkage between financial sector development and poverty alleviation, as well as employment creation.

The central question is how to develop a well-functioning financial sector and build its capacity so as to exploit its potential contribution to economic development.

Channel: Capacity of financial systems to perform multiple functions and not mere existence of the systems.

Multiple Functions

Illustrative Case of the Stock Markets

Stock market liquidity is positively and robustly correlated with contemporaneous and future rates of economic growth, capital accumulation and productivity growth.

Stock market liquidity promotes investments in longer-run or long-duration, yet high return, projects that would otherwise be foregone. Investors can readily trade their stake.

Stock markets allow for risk-sharing, which in turn allows firms to mobilize capital at a lower cost of capital.

Valuable projects are now adopted which might have been rationed out in the absence of a well-functioning stock market. As many firms face improved stock market opportunity, the aggregate economy also benefits.

Stock markets promote efficient governance of a listed companies by exerting external pressure and discipline on management.

Multiple Functions

Illustrative Case of the Stock Markets

Stock market liquidity is positively and robustly correlated with contemporaneous and future rates of economic growth, capital accumulation and productivity growth.

Stock market liquidity promotes investments in longer-run or long-duration, yet high return, projects that would otherwise be foregone. Investors can readily trade their stake.

Stock markets allow for risk-sharing, which in turn allows firms to mobilize capital at a lower cost of capital.

Valuable projects are now adopted which might have been rationed out in the absence of a well-functioning stock market. As many firms face improved stock market opportunity, the aggregate economy also benefits.

Stock markets promote efficient governance of a listed companies by exerting external pressure and discipline on management.

Stock Markets and Development Multiple Functions as a Channel

Stock Market

Development

Capitalization

Liquidity

Volatility

Global

Integration

Economic Development

Economic Growth

Capital Accumulation

Productivity Growth

Saving Rates

14

A Closer Look at the African Financial

Development Gap*

Measuring the African financial development gap:

Obtain predicted levels of financial development for SSA countries, based on

regression analyses of other low- and middle-income countries

For the majority of SSA countries, the actual levels of banking sector

development are below predicted levels

Analyzing determinants of financial development:

Population density seems to matter more for Africa;

Natural resources ‘curse’: Similar in Africa and elsewhere;

Macroeconomic conditions and institutional environment: Not as important

[Allen, Carletti, Cull, Qian, Senbet, Venzuela (NBER,2012)]

15

Summary statistics Allen, Carletti, Cull, Qian, Senbet (NBER, 2012)

World (minus Africa) Africa Variable

Mean Standard

Deviation

Mean Standard

Deviation

Liquid liabilities / GDP 64.2% 47.4% 27.5% 17.7%

Private credit / GDP 57.7% 45.3% 17.6% 22.7%

Stock Market Capitalization / GDP 52.1% 60.0% 25.6% 43.8%

Stock Market Value Traded / GDP 34.1% 50.9% 6.5% 20.0%

Ln(Population) 2.44 1.59 2.24 1.33

Ln(Population density) 0.44 1.94 0.09 0.12

Natural resources 0.5 2.41 0.15 0.77

Offshore center 4.4% 20.7% 0.0% 0.0%

Ln(Per capita income) 2.25 1.04 0.38 0.94

Population * GDP per capita 0.48 1.35 0.03 0.07

Real GDP growth rate 4.1% 2.5% 4.8% 2.7%

Inflation rate 5.2% 5.2% 9.3% 15.0%

Current Account balance / GDP 0.2% 8.1% -3.8% 6.7%

KKM index 0.33 0.9 -0.54 0.58

Bank concentration 0.65 0.19 0.81 0.14

Foreign ownership share 27.1% 25.9% 44.4% 24.4%

State ownership share 15.9% 19.7% 13.3% 16.6%

Manufacturing / GDP 16.8% 6.1% 11.0% 7.3%

Secondary/Primary school enrollment 0.81 0.24 0.33 0.18

Roads / Area 1.07 1.65 0.21 0.22

Railroads / Area 0.03 0.03 0 0

Urban population 63.6% 20.7% 36.2% 17.2%

Geographic branch penetration 29.76 80.07 7.97 22.49

Demographic branch penetration 16.51 17.28 2.86 3.64

16

Benchmarking Financial Development

FDi = α + β1Populationi Exogenous determinants, based on Beck et al.

+ β2Population Densityi (2008)

+ β3Natural Resourcesi

+β4Offshore Centeri

+β5Per Capita Incomei Plausibly exogenous, Financial development

+β6Population*GDP Per Capitai affects these variables at a lag, Beck et al. (2008)

+β7Real GDP Growth Ratei Macroeconomic variables

+β8Inflation Ratei

+β9Current Account Balance/GDPi

+Β10KKM Indexi Index of institutional development

+ β11Bank Concentration Banking sector structure and ownership variables

+Β12Foreign Ownership Sharei

+Β13State Ownership Sharei

+Β14Manufacturing/GDPi Other variables

+Β15Secondary/Primary enrolment

+ εi

17

Regressions for non-African countries

Liquid liabilities / GDP Private credit / GDP

All Low + Middle income All Low + Middle income

(1) (2) (3) (4) (5) (6) (7) (8)

Ln(Population) -0.017 -0.003 -0.001 -0.035 0.003 0.015 0.002 -0.027

(0.021) (0.028) (0.019) (0.030) (0.018) (0.021) (0.017) (0.026) Ln(Population Density) 0.074*** 0.031 0.036 0.032 0.018 0.019 0.032* -0.020

(0.023) (0.027) (0.022) (0.022) (0.019) (0.020) (0.019) (0.019)

Natural Resources -0.038*** -0.069*** -0.034 -0.062* -0.022* 0.0002 -0.010 -0.026 (0.014) (0.019) (0.033) (0.036) (0.012) (0.014) (0.028) (0.031)

Offshore Center 0.247* 0.133 0.369*** 0.341*** 0.191 0.159 0.374*** 0.339***

(0.145) (0.170) (0.112) (0.121) (0.123) (0.127) (0.096) (0.102) Ln(Per Capita Income) 0.222*** 0.061 0.056 -0.091 0.275*** -0.016 0.089** -0.063

(0.036) (0.083) (0.039) (0.065) (0.031) (0.062) (0.034) (0.055)

Population * GDP Per Capita

0.004 -0.013 0.006 0.061 0.071** 0.062** -0.031 0.015

(0.032) (0.033) (0.100) (0.101) (0.027) (0.024) (0.086) (0.084)

Real GDP Growth Rate -2.015 -2.619** -3.129*** -1.769** (1.514) (1.159) (1.126) (0.974)

Inflation Rate -1.219 -0.946* -1.092** -0.894**

(0.751) (0.505) (0.559) (0.424) Current Account Balance /

GDP 1.519*** 1.565** 0.392 1.236**

(0.556) (0.658) (0.414) (0.553) KKM Index 0.239*** 0.215*** 0.362*** 0.210***

(0.093) (0.080) (0.069) (0.067)

Manufacturing / GDP -1.313** 0.436 -0.127 0.651 (0.652) (0.580) (0.485) (0.487)

Secondary/Primary

Enrollment -0.335 -0.040 -0.130 -0.004

(0.241) (0.179) (0.179) (0.150)

Constant 0.383*** 1.188*** 0.467*** 0.990*** -0.041 0.782*** 0.248*** 0.640***

(0.123) (0.223) (0.101) (0.167) (0.104) (0.166) (0.087) (0.141)

Adjusted R2 0.41 0.51 0.14 0.36 0.54 0.70 0.22 0.43

Observations/Countries 111 97 75 67 111 97 75 67

18

Private credit/GDP: Actual vs. predicted values

19

Population Density: Africa (2000)

20

Explaining the African Financial Development Gap

(Regressions for SSA) Liquid liabilities / GDP Private credit / GDP

All Without South Africa All Without South Africa

(1) (2) (3) (4) (5) (6) (7) (8)

Ln(Population) -0.035 -0.004 -0.029 -0.011 -0.058** -0.021 -0.007 0.013

(0.026) (0.026) (0.031) (0.030) (0.024) (0.023) (0.022) (0.021) Ln(Population

Density)

0.074*** 0.080***

0.075*** 0.077***

0.0314* 0.049**

0.043*** 0.061***

(0.019) (0.022) (0.020) (0.024) (0.018) (0.020) (0.014) (0.016) Natural Resources -0.033 -0.013 -0.032 -0.010 -0.030 -0.001 -0.024 -0.015

(0.036) (0.047) (0.037) (0.049) (0.033) (0.041) (0.027) (0.034)

Offshore Center - - - - - - - -

Ln(Per Capita Income) 0.038 0.022 0.043 0.018 0.009 0.054 0.048* 0.073

(0.035) (0.078) (0.037) (0.080) (0.032) (0.068) (0.027) (0.056) Population * GDP Per

Capita

0.441 -0.281

0.057 0.221

2.941*** 2.396***

-0.141 -0.163

(0.520) (0.508) (1.12) (1.197) (0.477) (0.442) (0.816) (0.834) Real GDP Growth

Rate

-0.447

-0.499

-0.607

-0.343

(1.031) (1.057) (0.898) (0.736) Inflation Rate 0.060 0.058 -0.076 -0.066

(0.192) (0.196) (0.167) (0.136)

Current Account Balance / GDP

-0.082

-0.207

-0.879*

-0.241

(0.587) (0.656) (0.511) (0.457)

KKM Index 0.116* 0.119* 0.073 0.058 (0.062) (0.063) (0.054) (0.044)

Manufacturing / GDP -0.376 -0.341 -0.085 -0.265

(0.455) (0.470) (0.396) (0.327) Secondary/Primary

Enrollment

0.372

0.379

0.179

0.144

(0.247) (0.252) (0.215) (0.175) Constant 0.548*** 0.528*** 0.545*** 0.518*** 0.297*** 0.260* 0.275*** 0.309***

(0.078) (0.2613) (0.079) (0.3044) (0.071) (0.130) (0.058) (0.243)

Adjusted R2 0.36 0.53 0.34 0.52 0.64 0.78 0.24 0.45 Observations/Countries 38 33 37 32 38 33 37 32

21

Remarks

Document the African financial development gap:

Comparing actual banking sector development measures with predicted levels

based on the analyses of other developing countries

Analyze factors that are associated with fin. development:

Importance of population density: Role of mobile banking technology?

Natural resource curse;

Macroeconomic conditions and institutional environment

Ongoing work:

Nonlinear relation between pop. density and banking development?

World Bank firm-level surveys;

Household surveys in Kenya.

Toward Resolution of Financial

African Development Gap

Kenya and Equity Bank

Sub-Saharan African countries have undergone extensive

economic/financial sector reforms over the last few decades.

Yet, many still face a severe financial development gap

relative to advanced and other peer developing economies.

A key obstacle to financial development is access by the

disadvantaged to financial services, which could promote

economic growth at the broadest scales.

In view of the important role of financial inclusion, study

study the expansion strategies of Equity Bank and other banks,

and their impact on access to banking services in Kenya.

Why Kenya?

Kenya’s financial development indicators are among the best in the Sub-Saharan Africa region.

Focusing on a specific country avoids the difficulties of cross-country studies regarding omitted (or poorly measured) country-level factors.

A ‘laboratory’ for the study of financial access as it has witnessed a general expansion in bank branching and the emergence of Equity Bank, which targets low income clients and traditionally under-served geographic districts.

Why Equity Bank?

Equity Bank is a pioneering institution that devised a strategy targeting low income clients and traditionally under-served geographic areas.

It is now the third largest listed company in Kenya by market capitalization.

It does not have any government ownership.

It has 55% of the deposit accounts in Kenya and 112 branches.

Integration of the informal into formal

It has began exporting its business model to other African countries: Uganda (42 branches) and South Sudan (3 branches), and is expanding in Tanzania and Rwanda.

Equity Bank’s Business Model

The business model of the bank is based on affordability and accessibility:

Affordability: To open a bank account only requires an ID and a photo (which can be taken in the branch itself). By contrast, foreign banks, such as Barclays, require a minimum balance of about US$ 222.

Accessibility: Local languages are spoken in its branches. In central Kenya, 30-40% people speak only a minority language.

Questions

Does Equity Bank pursue different

branching strategies from other commercial

banks?

If so, do these expansion strategies lead to

different outcomes for household access to

banking services?

And do these outcomes differ by

demographics and districts?

Data

Combining a new dataset on bank penetration at the district level with household level survey data:

Bank penetration dataset

Based on branch-level information aggregated as a district-level panel on the number of branches by bank.

Covers 45 commercial banks that operated in 65 Kenyan districts in the period between 2006 and 2009.

FinAccess household surveys

Conducted by Financial Sector Deepening Trust Kenya.

4,420 completed interviews in 2006 and 6,598 in 2009.

Data on access to financial services and individual/household characteristics.

Banking Branch Expansion

The Kenyan banking system expanded 68% between 2006 and 2009 in terms of the number of branches

Expansion in all bank categories: domestic private, foreign, and government

Expansion occurred not only in urban districts but also rural, arid and semi-arid districts

However, expansion primarily driven by domestic private banks, with Equity Bank playing a major role

Equity Bank branch expansion 155% (110 from 44)

Domestic private banks 2006 2009 Change % Change

CharterHouse Bank Ltd. 10 10 0 0

National Industrial Credit Bank Ltd. 16 16 0 0

Commercial Bank of Africa Ltd. 19 20 1 5

Equity Bank 44 112 68 155

Co-operative Bank of Kenya Ltd. 52 83 31 60

Sub-Total 247 450 203 82

Foreign banks 2006 2009 Change % Change

K-Rep Bank Ltd. 22 30 8 36

Standard Chartered Bank Kenya Ltd. 31 35 4 13

Barclays Bank of Kenya Ltd. 62 119 57 92

Sub-Total 150 258 108 72

Government and government-influenced banks 2006 2009 Change % Change

Consolidated Bank of Kenya Ltd. 12 13 1 8

CFC Stanbic Bank Ltd. 16 35 19 119

National Bank of Kenya Ltd. 33 43 10 30

Kenya Commercial Bank Ltd. 117 169 52 44

Sub-Total 179 262 83 46

Total 576 970 394 68

Bank

Branch

Expansion

Bank Expansion Strategies

Stylized Facts

See Figures:

All bank groups exhibited substantial branch expansion between 2006 and 2009

All groups showed higher penetration in urban, highly populated, and educated districts

Domestic private banks had greater presence in under developed districts, and foreign banks had the least presence in those districts

Domestic privates are lead by Equity Bank – playing vital role in fostering banking services in under developed districts

Now formal analysis

Branch Expansion: Urban

districts

0

50

100

150

200

Foreign banks Govt banks Local private banks

Urban Districts

2006 2009

Branch Expansion: Low

Population Density Districts

0

50

100

150

200

250

300

Foreign banks Govt. banks Local private banks

Low Population Density Districts

2006 2009

Branch Expansion: High Minority

Language Districts

0

50

100

150

200

250

300

Foreign banks Govt. banks Local private banks

High Minority Language Districts

2006 2009

Methodology

Bank Expansion Strategies: Regression Analysis

Branchesdt = α + μt + βXd + εdt

Use of Bank Accounts: Probit Model

Pr(Bankedidt = 1) = F(α + μd + βEquitydt + γBranchesdt + φzidt)

Access to Credit: Ordered Probit Model

The dependent variable takes the value:

0 = the individual does not have a bank account/loan,

1 = the individual has a bank account,

2 = the individual has a loan from a bank.

Branch Expansion Strategies

Whole Sample Urban Excluded

Dep. variable: Number of branches over

number of banks

Equity Bank

excluded Equity Bank

Equity Bank

excluded Equity Bank

Rural -3.403** -6.440 0.101** 0.834**

Arid and Semi-Arid -3.504** -7.276*

log( Density population) -0.068 -0.311** -0.019 -0.191**

Language: Minority language -4.961** -17.880*** -1.119** -7.685***

Language: Swahili -5.047** -18.666*** -1.146** -8.194***

Dummy (2009=1) 0.101** 1.045***

log( Density population) x d2009 0.007 0.049

Language: Minority language x d2009 0.009 0.708**

Language: Swahili x d2009 0.035 0.539

Constant 8.567*** 25.869*** 1.193** 8.364***

Observations 129 129 125 125

Adjusted R-squared 0.748 0.524 0.217 0.204

Use of Banking Services and

Equity Bank Presence

Dep. variable: Bank account (1) (2) (3) (4) (5)

Bank branches 0.0010***

Equity Bank presence 0.0424*** 0.0222** 0.0555***

Foreign bank presence 0.0255 0.0273

Gov. influenced banks presence 0.0298** 0.0287*

Local Private banks presence 0.0392** 0.0216

Foreign bank branches 0.0044 0.0103***

Gov. influenced bank branches 0.0019 -0.0019

Local private bank branches -0.0028 -

0.0072***

Observations 10922 10922 10922 10922 10922

Pseudo R-squared 0.332 0.326 0.327 0.331 0.333

District Fixed Effects YES YES YES YES YES

Control Variables YES YES YES YES YES

Access to Credit

Ordered Probit Average Marginal Effects

Financial Financial Financial

Access=0 Access=1 Access=2

Bank branches 0.0039*** -0.0007*** 0.0005*** 0.0002***

Equity Bank presence 0.2637*** -0.0496*** 0.0360*** 0.0135***

Observations 10922

Pseudo R-squared 0.2918

District Fixed Effects YES

Control Variables YES

Endogeneity Issue and Additional

Tests

Difficult to establish impact if branch expansion is non-random

Instrumental variables Based on Equity Bank’s shift in banking strategy,

business model

% of people speaking a minority language in a district

Difference-in-differences Look at districts with no Equity presence in 2006

Compare change in likelihood of account for

(a) Districts Equity had entered by 2009 [treatment]

(b) Districts without Equity presence 2006,2009 [control]

IV, Diff-in-Diff Results IV GMM IV Probit Difference in Differences

Dep. variable: Bank account (1) (2) (3) (4) (5)

First stage

Minority language district -0.9086*** -0.9069***

Minority language district*2009 0.2313*** 0.2333***

Second stage

Bank branches 0.0012*** 0.0010*** -0.0021

Equity Bank presence 0.0939*** 0.0984*** 0.0293** 0.0198** 0.0280**

Foreign bank presence 0.0038

Gov. banks presence 0.0181**

Local Private banks presence 0.0095

Foreign bank branches -0.0026

Gov. bank branches -0.0007

Local private bank branches -0.0034

Observations 10922 10922 5314 5314 5314

Centered R-squared 0.759

Partial R-square of excluded IVs 0.2822

p-value of excluded instruments 0.0000

p-value of Hansen J statistic 0.1924

Pseudo R-squared 0.348 0.348 0.348

District Fixed Effects YES YES YES YES YES

Control Variables YES YES YES YES YES

Conclusions and Main Findings

We study the branch expansion strategies of Equity Bank and other banks, and their impact on access to banking services in Kenya in view of the vital role of financial inclusion in developing economies.

Kenya 2006-2009 offers a “laboratory” for the study of financial access, especially in light of the emergence of Equity Bank.

The presence of domestic private banks (including Equity Bank), government or government-influenced banks, or foreign banks is associated with increased financial access at the district level.

Conclusions and Findings - Contd

Controlling for branching by other banks,

Equity Bank presence is strongly

associated with greater usage of bank

accounts and bank loans.

Effect strongest for individuals with low

income and limited education, and for

households that do not own a permanent

home and that have no member with a

salaried job.

Caveats

Over half of savings accounts in one bank

Concerns about banking system stability

Concentration of bank accounts likely to pose

challenges to the deposit insurance system

Jury is still out on sustainability of Equity

strategy. Also Replicability?

Equity Bank expanding into other African

countries: the bright and the dark for Kenya and

others