March 2002 Insights Issue #40

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Banking reforms in Africa
What has been learnt?

One of the major objectives of liberalisation is to boost bank lending to the private sector, which is regarded as the engine of economic growth. However, the growth of commercial bank lending to the private sector following financial liberalisation was disappointing in many countries, especially bank lending to small scale borrowers and start-up enterprises.

Many countries in sub-Saharan Africa liberalised their financial sectors in the late 1980s or 1990s to encourage greater financial efficiency. Policy reforms included: removing interest rate controls, removing requirements on banks to lend to specific sectors, privatising state-owned banks, and allowing easier entry by private sector banks and non-bank financial institutions (NBFIs), including foreign banks. At the same time, to promote sounder banking and help protect bank deposits, reforms were introduced to strengthen the prudential regulation (rules and regulations designed to restrict banks from taking excessive risks with depositors' funds) and supervision of banks by improving banking laws and expanding supervisory capacities.

It has proved difficult for commercial banks to build up sound commercially viable loan portfolios, for several reasons:

• Domestic private sectors are weak: few creditworthy borrowers exist.
• Banks face acute problems of information (concerning the viability and creditworthiness of borrowers) and contract enforcement problems which increase the risk of loan default.
• High inflation and exchange rate volatility has exacerbated the risks of lending in some countries.
• Large government deficits in some countries, which have to be funded through sales of treasury bills to domestic financial markets to avoid inflationary growth of the money supply, have crowded out private sector borrowers from the credit markets.

Financial liberalisation has changed the nature of the risks facing the banking system. Reforms have reduced the risk of bank distress caused by governments directing banks (government-owned banks in particular) to lend to unviable and uncreditworthy borrowers. New sources of risk have emerged, however: greater competition is squeezing the profits of weaker banks; the entry of new banks that lack the expertise to manage risks in liberalised markets; greater opportunities for fraud and abuse of depositors' funds by banks and NBFIs; and risks arising from foreign exchange denominated transactions such as lending by banks in foreign exchange and the contracting of foreign exchange liabilities by banks.

Kenya, Nigeria, Uganda and Zambia and others have suffered from the failure of privately owned banks and NBFIs - often due to fraud and abuse by managers and owners, especially insider lending. These bank failures have proved costly for taxpayers, who have often had to fund the reimbursement of deposits. Many of the failures exposed serious weaknesses in prudential systems: prudential regulations were not properly enforced and distressed banks were allowed to continue operating, often with financial support from central banks and governments, for too long after they had become insolvent, merely increasing the eventual cost of collapse.

What should governments do? To encourage the growth of bank lending to the private sector, governments should:

• Maintain macroeconomic stability and avoid financing large fiscal deficits from the domestic banking system.
• Accumulate savings in the domestic banking system to create more room for private sector borrowing: in Uganda in the 1990s, fiscal reforms enabled the government to accumulate bank savings, which in turn facilitated a strong recovery in private sector bank credit.
• Improve the institutional environment for bank lending by strengthening the commercial legal system, so that banks can enforce contracts and foreclose on defaulters without long delays.
• NBFIs - leasing companies, merchant banks, mortgage institutions, microfinance institutions for example - good at filling specific niches in the financial markets, need support and encouragement. Most commercial banks are not suited to lending to the small scale enterprises likely to prove crucial to future growth.

Liberalised financial markets require strong, impartial supervision, independent of political interference, to protect depositors' funds. While many countries have brought their banking laws into line with what is regarded as best practice, better enforcement of prudential regulations is essential. Regulators must force insolvent banks to be re-capitalised by their owners or by new owners, or close them down promptly. Since supervisory resources are scarce, regulatory agencies must focus their limited resources on those banks and NBFIs which pose the greatest prudential risk.

Martin Brownbridge
Institute for Development Policy and Management (IDPM)
University of Manchester
Manchester M13 9GH
UK

MartinBrownbridge@hotmail.com

See also

'Financial regulation in developing countries' Journal of Development Studies 37/1 by Martin Brownbridge and Colin Kirkpatrick, 2000

'Banking in Africa: The impact of financial sector reform since independence', James Curry: London by Martin Brownbridge and Charles Harvey, 1998