CHALLENGES OF FINANCIAL SECTOR REFORMS IN AFRICA Louis Kasekende Chief 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%

II. The Record of Reform The 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 n Cleaning the financial system after decades of overregulation can be costly n Preparing the Uganda Commercial Bank cost 2% of GDP in 1998 n Recapitalizing the Central Bank cost 1% of GDP n When privatizing large state-owned banks, it is advisable to get a strategic partner with substantial financial, technical and managerial resources at their disposal n 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