March 2002 Insights Issue #40

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A foreign affair?
How far does Africa need foreign banks?

Free foreign bank entry is essential to financial liberalisation in Africa. It is also integral to the World Trade Organisation (WTO) protocols on the General Agreement on Trade in Services (GATS) embraced by most African governments. What are the pros and cons of free foreign bank entry? What are the implications for local domestic banks?

Foreign banks are central to the evolution of African banking. In colonial times, formal banks were foreign. Post-independence in the 1960s saw the creation of a two-tier banking system, with a central bank responsible for monetary policy, and several commercial banks handling deposits and loans. The lending objectives of foreign banks, however, severely marginalised indigenous entrepreneurs. Some governments intervened by nationalising foreign banks - most are now insolvent and either privatised or sold to foreign owners.

Recent research by the Birmingham Business School and the Institute for Development Policy and Management examined how open 26 African economies are to foreign participation in their domestic banking markets. Key findings include:

• Foreign banks can be totally involved in smaller economies such as Lesotho and Swaziland. A small domestic market means that locally-owned banks cannot recover high set-up costs as foreign banks can from profitable operations elsewhere.
• Financial liberalisation increases the degree of access by foreign banks. Foreign banks in Tanzania had only 5 percent access pre-1980 when policies were restrictive. This figure has now risen to 76 percent. So too the trend in Ethiopia (at 2 percent because of its barriers to entry under a Marxist regime) is now expected to change.
• Although bank loan growth patterns are similar for both domestic and foreign banks, increased foreign participation reduces the variability of loan supply.
• Contrary to expectation, foreign and domestic banks both shoulder a considerable amount of non-performing loans, possibly due to differences in accounting practices.
• Foreign banks are more profitable but not necessarily better capitalised than their local counterparts.

Mixed blessings? The pros and cons of foreign bank entry

Foreign banks directly improve the quality, pricing and availability of financial services. They engender competition with domestic banks and improve financial system architecture, for example, accounting, auditing, transparency, and risk management. Foreign banks also increase competitiveness and efficiency leading to better quality customer services.

However, foreign banks can destabilise domestic bank credit by providing additional channels for capital flight. Foreign-owned banks also tend to withdraw quickly from the domestic market in the face of financial crisis, as was the case in South East Asia. In addition, foreign banks use their financial power to cherry pick the most lucrative transactions, thus relegating domestic banks to more risky markets.

How should African governments respond?

• Where there is too much foreign bank involvement, local private banks should be encouraged to merge and expand to become more viable.
• Policy makers should not be complacent regarding the liquidity and capitalisation of foreign banks, even if the banks fall under the jurisdiction of the parent country. Both domestic and foreign banks should be subjected to the same regulatory regime, and the level of monitoring should be equally strict.
• By designing policies that enhance foreign bank participation for example setting up new banks or privatising state-owned banks.
• Sequencing is crucial. It is important to strengthen and enhance the international competitiveness of the domestic banking system before opening up fully to foreign entry.

Victor Murinde
Birmingham Business School
University of Birmingham
Edgbaston
Birmingham B15 2TT
UK

T +44 (0)121 414 6704

V.Murinde@bham.ac.uk
Victor.Murinde@man.ac.uk

Moses Tefula
Institute for Development Policy and Management
University of Manchester
Oxford Road
Manchester M13 9GH
UK

T +44 (0)161 275 2827

Moses.Tefula@man.ac.uk

http://idpm.man.ac.uk/idpm/idpm_dp.htm#F_DWP