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The Structure of Financial Sectors and the Pace of Growth of Finance
Returning to the issue of structure of the financial sector, as it relates to categories of financial institutions, Griffith-Jones et al. (2016) discuss the potential importance of public development banks as part of this mix as one of the insights that have been ‘rediscovered’ since 2008. The crisis showed how development banks could play a crucial counter-cyclical role, stepping in when private finance dried up. This prompted a broader reassessment of their record and potential. Once common in many countries, the record of development banks has not always been positive. Following a series of influential studies linking government-owned banks to lower growth, many development economists assumed they were a thing of the past. Theoretically, this reflected a very neoclassical view of finance, which believed almost ex ante that private finance was superior to public finance, without much review of empirical evidence.
But this was never true. Development banks have been central to the growth of large emerging economies (e.g., Brazil, India, and China), and remain integral to the financial landscape in Germany. As well as playing a counter-cyclical role, these institutions can help provide the long-term ‘patient’ finance, that is key to the development process, but which the private sector rarely provides at the scale needed.
Furthermore, development banks may be valuable for funding structural transformation, for example towards a more sustainable (in the environmental sense) and a more inclusive economy; public development banks, in both developing and developed economies, can play a key role for example in the transition to more renewable energy, as the German public development bank, KfW has so successfully done. More recent research, which controls properly for institutional quality, does not find that government ownership of banks is associated with lower growth. Indeed, when the crisis period is included, the opposite may be true. By implying a more diversified financial system, public development banks seem to contribute to financial stability.
As argued by Griffith-Jones et al. (op. cit.) and supported by the evidence in Spratt (2016), there thus remains a strong case for public development banks. There are risks, but the experience of several countries shows that these can be overcome. The question may therefore be not whether to create a development bank per se, but how to design and run a good development bank.
The final issue in this section seems to be the most important one. As has been understood by those working on financial crises in developing and emerging countries for many years, this relates to the importance of the rate of credit growth. Independent of any threshold for the total size of the financial sector, an overly rapid expansion of credit—regardless of the starting level and the exact form this credit assumes—is strongly associated with financial crises.
Whether in the 2007/8 North Atlantic crisis, in the Nigerian financial crisis of2009, or in many of the financial crises that have occurred around the world since the 1980s, rapid credit expansion tends to see finance allocated inefficiently (lowering long-term growth prospects), and asset price bubbles inflated, triggering instability and subsequent collapse. Given the perennial nature of such events, with us in one form or another for hundreds of years (but apparently accelerated in recent decades), there is every reason to think they will continue, unless financial regulation is far more effective. Rather than assuming that ‘this time it’s different’, Griffith-Jones et al. (2016) argue strongly that regulation needs to counter these trends, with counter-cyclical mechanisms deployed to dampen credit growth when this becomes excessive, and vice versa.
Financial systems in many African countries share features which seem to increase their vulnerability to shocks in the economic and financial system, including limited financial regulatory capacity, macroeconomic volatility linked to the economic structure of the countries (e.g. natural resource dependence, and concentration of exports, which implies volatility of their terms of trade) and political pressure for financial deepening with a view to developing the real economy.
Fast credit growth might exacerbate vulnerabilities and enhance the risk of financial crises, as it has done in all other regions of the world. In the African context, the case of Nigeria provides a fairly recent illustration that banking crises might reflect a negative causation link between financial deepening and growth, even at relatively low levels of financial development. In 2004/2005 the Central Bank of Nigeria (CBN) mandated a steep increase in the minimum level of bank capitalization with a view to creating large internationally competitive banks and increase financial depth (Soludo 2004). Banks achieved this capitalization, which was high even by international standards, by means of equity investment, mergers and acquisitions, resulting in the consolidation of the banking sector, whereby the total number of banks declined from 89 to 25 banks. The consolidation in the domestic banking sector, along with abundant capital flows in the wake of rising oil prices, increased the speed of credit creation with significant flows to sectors with little growth impact. Between 2006 and 2009 private credit tripled from 12 per cent to 36 per cent of GDP. In real terms (2002 prices) this meant that domestic borrowing by the private sector grew almost fivefold. (Griffith-Jones et al. 2016)
This growth of credit included loans used to finance share purchases, clearly an undesirable practice, setting the stage for a financial asset bubble, particularly in bank stocks (Sanusi 2010). The financial sector boom ended in a bust with a systemic banking crisis, accentuated by the impact of the North Atlantic crisis in 2009, as financial sector growth was excessive, partly because it had not been accompanied by the corresponding regulatory and supervisory upgrade. Consequently, non-performing loans as percentage of gross loans rose sharply from 9.5 percent in 2007 to almost 30 percent in 2009. Finally, nine financial institutions that were close to collapse had to be rescued at the total cost of US$4 billion. The cost of cleaning up the balance sheets and recapitalizing the banks concerned has been estimated at about 2.4 trillion Naira, equivalent to almost 8 percent of the country’s GDP (IMF 2011). The Nigerian crisis provides additional evidence that there is no reason for complacency about the need for rigorous financial regulation in the African economies, especially in the face of rapid credit expansion.
With respect to the effects of foreign bank presence on financial stability and growth in Africa, the existing evidence is somewhat ambiguous and requires further research (for an interesting recent book, see Beck et al. 2014). There are indications that foreign banks can bring in experience from other regional economies and that they can help exploit scale economies in small host countries. Yet the benefits for financial access remain ambiguous, partly because of the greater reliance of foreign banks on so-called ‘hard’ information about borrowers as opposed to soft information, which often implies a focus on prime borrowers (Detragiache et al. 2008; Sengupta 2007).
Furthermore, it seems that foreign banks are fundamentally different from domestic banks. As argued by Rashid (2011), foreign banks seem less inclined to lending and their loans are likely to be more volatile than those offered by domestic banks. Despite strong foreign bank presence, the effects of the global financial crisis on African banks have been limited. In part, this is due to the relatively limited presence of banks from developed economies in Africa (with a high proportion of foreign banks currently being regional ones, which is different from previous decades when foreign banks were predominantly developed country ones—see Brownbridge et al. 1998) and the fact that existing subsidiaries mostly fund themselves locally and not via their parents. This, however, limits the contribution that these foreign banks make to national savings (Fuchs et al. 2012a). In addition, reportedly large capital buffers—often above levels required by Basel III—have served to increase the resilience of African banks during the global financial crisis, although this may have involved some costs for intermediation (Fuchs et al. 2012b).
The fact that financial sectors in LICs tend to be relatively smaller and simpler provides an advantage in that governments have more policy space to influence the future nature and scale of their financial system. Furthermore, the fact that the financial sector is smaller may imply that it is politically less powerful; thus, potentially, this gives more autonomy to regulators and—more broadly governments—to shape the financial sector.
Thus, LICS have, on the one hand, the advantage of being latecomers to financial development and can benefit from positive and negative lessons from experiences and research on other countries. On the other hand, the incompleteness of LIC financial systems means that important challenges remain on extending access (to all types of financial services) to those excluded, such as a high proportion of poor households, microenterprises and SMEs. More generally, it is difficult to fund working capital and investment, especially for SMEs (and particularly at low spreads and longer maturities) crucial for growth and employment generation. The financing of infrastructure is a well-known problem in LICs, and the mobilization of sufficient long-term finance, as well as the most effective way to channel it to investment in that sector, is a key area of policy.
Another key issue is how financial structures affect inclusive growth and stability in LICs, and how financial regulation affects these structures, as well as the behaviour of financial sector actors. This relates mainly to three categories: the supply of finance (including access to finance); the cost of finance; and the maturity of finance.
Given the dominance of banks in LIC financial systems, and the importance of credit in determining growth and stability outcomes, the focus of our analysis is largely on bank credit. As LICs generally lack the structural features required to obtain the benefits of capital markets— such as sufficient liquidity, for example—policymakers in LICs should focus on improving the impact of the banking sector on growth and stability, and ensuring that the capital account is managed carefully to support this goal.
The first area to consider, as discussed above, is the supply of finance to firms and households. In both cases, access to finance (of any kind) is a major issue in LICs. Firms, particularly small and medium-sized enterprises (SMEs), regularly cite lack of external finance as the major constraint to growth. Financial inclusion of households in LICs is also the exception rather than the norm. Many of the reasons are the same: information on creditworthiness is rarely available in third-party form; the transaction costs of lending small amounts are high; borrowers may be located in relatively remote rural areas. As we saw in the tables above, the total size of the financial sector—i.e., the total credit available—is relatively low, and bank branches are few. As a result, finance tends to flow to activities less affected by these problems, such as blue-chip corporates and government.
Regulation can be used to reduce these problems for incumbent institutions: encouraging information sharing and credit bureau, and fostering innovative practices to reduce transaction costs, for example. Increasing the supply of finance to diverse sectors is likely to be easier with a diverse set of financial institutions: large and small banks; diversified and sector-specific; commercial and development-oriented, public and private. Microfinance institutions (MFIs) credit unions, cooperative banks and mobile banking will be a part of this. As well as supporting financial inclusion (households) and inclusive growth (SMEs), such an ‘ecosystem’ may also be positive for financial stability, as institutions will be exposed to different sectors and risks.
The argument for diversity also applies to large-scale infrastructure projects, which also face severe—though different—financing constraints. The case made for development banks is also relevant here. There is more potential to involve external financial institutions in infrastruc?ture. Often these will be multilateral or bilateral development banks, with commercial institutions also participating in projects. The presence of an effective national public development bank is likely to increase the likelihood of successfully financing such projects, and improve their development outcomes (interview material).
There is an important case for the comprehensive regulation of all financial institutions. Also, regulation should be tailored to the specific characteristics of different sectors. If the aim is to encourage institutions to act in different ways, then regulation should be designed to support rather than stifle this. Though regulation should be comprehensive, it should be proportionate to the scale and the systemic risk of financial institutions, as well as their specific features.
‘Unsustainable’ debt is likely to lead to financial instability, whether for the private sector, households, or government. A large part of this relates to the cost of credit. As illustrated in Table 4.3, average spreads in LICs are double those of MICs, and three times the average in HICs. That profit levels are similarly divergent suggests this is not simply a reflection of higher risk. Costs are also higher, but not enough to account for the difference in spreads. For many, this suggests that competitive pressures are not strong enough. As pointed out below, however, it is noteworthy that there is little evidence that measures to increase competitiveness have been effective in reducing spreads.
For households and individuals, the cost of credit is also important, with much debate focusing on the high rates charged by many MFIs. While not certain, it is more likely that MFI rates more accurately reflect risk than is the case with commercial banks. This does not mean that the resulting debts are sustainable, however. Credit will only be developmentally beneficial—to firms, households, or indeed governments, if invested in activities with returns greater than the rate of interest charged. Increasing levels of non-performing loans (NPLs) in the microfinance sector suggest, at the very least, that this is not always the case. Debates on whether MFI rates should be capped continue.
As was seen very clearly in the US subprime market, extending credit to the financially excluded is not an end in itself. It will only be benefi- cial—for both inclusive growth and stability—if borrowers can invest this finance productively, and if they have the financial capacity to pay them back. If not, the extension of credit is liable to make matters worse, not better, for poorer borrowers, as well as for financial system stability.
If government borrows at very high rates, resultant debt service payments reduce its ability to fund other activities. If financial institutions in LICs can obtain very good returns by just lending to government at high, risk-free rates, they will be less inclined to lend to the other parts of the economy. By providing financial instruments and building a yield curve, government borrowing is an important driver of financial sector development in LICs.
The final area to consider is the maturity of finance. Much of the finance that is available in LICs is short-term and expensive. As well as designing regulation to encourage banks to take a longer-term view, domestic investors such as pension funds that naturally take a long-term view, also given the long-term nature of their assets, and can commit large-scale finance are needed. This is a long-term process, but infrastructure needs in LICs are pressing and immediate. Again, we have a strong case for public development banks to help fill this gap.
External finance can also play a role, but international direct investors may demand very high returns to offset the risks they associate with LICs. This does not mean that there is no scope for such investment, but it is probably best deployed in conjunction with multilateral and bilateral development finance institutions, either as co-investors or as suppliers of risk mitigation. The creation of new development banks, like the AIIB and the BRICS bank, provide new and additional sources of finance for infrastructure (Griffith-Jones et al. 2016).
The issue of private capital flows and capital account management in LICs is key. Overall, the literature on the topic confirms that private capital flows, in some cases and under certain particular conditions, may carry important growth opportunities. A significant share of the literature focuses on the growth impact of FDI flows on growth in LICs, while much less quantitative work has been done on growth benefits of other types of private capital flows, especially bond flows and international bank lending. This is a cause of concern, as bond flows (especially to sovereigns) are becoming an important part of private capital flows in several sub-Saharan African LIC countries. Recent trends imply an increasing cost of bond borrowing by LICs, signaling an end of the boom-like enthusiasm for so-called frontier markets (Stiglitz and Hamid 2016).
Notwithstanding their growth benefits, private capital flows are also found to be a significant source of risks. Indeed, sudden surges in capital flows can lead to appreciation and volatility of real exchange rates, to inflation, stock market booms, and to credit expansion. Moreover, sudden capital flow reversals or stops can lead to depletion of reserves, sharp currency depreciations, as well as to currency and banking crises. This has happened on numerous occasions, and there is a risk again this could happen in LICs. Private capital flows are thus a double-edged sword, and therefore, it is important to develop adequate and effective capital account management policy tools.
A number of policy measures may help manage surges in capital flows. These include capital controls, macroeconomic measures (i.e., official foreign exchange intervention, exchange rate intervention, and fiscal policy), and structural reforms (i.e., financial sector reforms including prudential regulation and supervision, and easing restrictions on capital flows). The evidence on the types of capital account management tools that have been used in LICs over time is still limited and much more detailed information on the issues that might arise in implementing specific capital account management tools in LICs is needed.
The debate on the effectiveness of capital controls regained momentum in the aftermath of the 2008-09 crises. A broad consensus is emerging that capital controls may be a good tool to moderate the impact of capital flows (e.g., to prevent the build-up of financial sector risks), but they should be used in coordination with other macroprudential tools to prevent asset inflation and overvaluation. An important development is the significant change in position of the International Monetary Fund (IMF), which until not long ago had a position broadly against capital controls and favored capital account liberalization, while in the aftermath of the 2008-09 crises, it decided to endorse the use of capital controls under certain circumstances. (For a critique of the progress but also the insufficiency of the IMF position, which sees capital controls only as a tool of last resort, see Gallagher et al. 2012.)
A number of structural reforms may help manage capital flows. Financial sector reforms, which include among others prudential regulation and supervision, are a capital account management tool that aims to influence indirectly capital inflows or outflows with the objective of reducing the vulnerability of an economy to systemic financial crises. Particularly relevant in this context are regulations on currency mismatches in the balance sheets of financial and non-financial agents. In this context, it is important to examine whether regulatory measures should be done via domestic prudential policies (e.g., regulating currency mismatches in the balance sheets of banks) or through capital controls, by analyzing their respective advantages and disadvantages. More precisely, domestic financial regulation may work for loans channeled through the banking system, whereas loans lent to non-financial companies directly may require capital controls, if they become too large.
The evidence in the academic literature on the effectiveness of macroeconomic measures to manage capital flows is mixed across the different types of policy instruments, with fiscal tightening appearing to be the most effective macroeconomic policy tool, although it is difficult to implement, and can have negative effects on growth. The evidence on the effectiveness of prudential regulation is instead still scarce and controversial. In particular, there is a research gap on whether regulatory and supervisory practices originated in the developed world may be successful in LICs that are characterized by different structural features, stage of development, and institutional capacities.
African LICs are not insulated from financial globalization despite their relatively low levels of financial integration, and therefore are vulnerable to the destabilizing effects of financial shocks generated elsewhere, as well as in their own countries. There are big challenges this grouping of countries face in adopting complex regulatory approaches developed internationally, in how to deal with foreign banks in their jurisdictions, and how best to manage risks arising from financial integration, as a result of capital account liberalization.
African LICs are responding to complexity in financial regulation by slowing down on the implementation of the most challenging aspects of it, particularly with regard to Basel rules. Moreover, they are choosing regulatory tools that are simpler and more suitable to their needs. Also, they are investing in regulatory capacity, although important regulatory and supervisory gaps remain—for example, they still lack countercyclical tools to address systemic risks and insufficient assessment of foreign exchange position of banks, although interviews with African regulators indicate that they are making progress in these areas (interview material).
Capacity by regulators to deal with complex rules may be missing. However, complexity has recently been challenged both by developed country and developing country regulators, on the grounds of ineffectiveness and inappropriateness (see for example Haldane and Madouros). If simpler—and more effective—regulation is adopted by African LICs, then there is evidence (see Gottschalk 2015) showing that, on the whole, such countries do, on the whole, have the capacity to put in place a regulatory system appropriate to their needs and that is sufficiently good to ensure the safety of their financial systems. The few financial crises that the region has suffered more recently have had more to do with inappropriate policy choices than with capacity for effective banking regulation, as the Nigerian case discussed further below demonstrates.