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How to Deepen Financial Systems in Africa: All financial sector policy is local

Thorsten Beck's picture

Editor’s Note: This is the fifth and final contribution in a series of posts that preview the findings of the forthcoming Financing Africa: Through the Crisis and Beyond regional flagship report, a comprehensive review documenting current and new trends in Africa’s financial sectors and taking into account Africa’s many different experiences. The report was prepared by the African Development Bank, the German Federal Ministry for Economic Cooperation and Development and the World Bank. In this post, the authors argue that all financial sector reform has to start locally, taking into account political constraints, but also aiming to create a constituency for financial sector reform.

What has the recent crisis taught us about the role of finance in the growth process of countries? The global crisis and the ensuing Great Recession have put in doubt the paradigm that financial deepening is good for growth under any circumstance. For students of financial systems, the bright (growth-enhancing) and dark (instability) sides of financial development go hand in hand. The same mechanism through which finance helps growth also makes finance susceptible to shocks and, ultimately, fragility. Specifically, the maturity transformation from short-term savings and deposit facilities into long-term investments is at the core of the positive impact of a financial system on the real economy, but also renders the system susceptible to shocks. The role that finance has as a lubricant for the real economy likewise exacerbates the effect of financial fragility on the real economy. We therefore argue that instead of throwing out the baby with the bathwater, it is important to construct a regulatory and governance framework that minimizes the risk of fragility and provides policy makers with better possibilities for managing bank failures in a way that is incentive-compatible. If there is a lesson to be learned in Africa from the crisis, we think it is that the growth benefits of a well-developed financial system can only be reaped in a stable macroeconomic environment protected by an appropriate regulatory and supervisory framework and strong internal bank governance. This means there should be more transparency and accountability in bank management, less direct government intervention in the regulatory and supervisory process, and a focus on building up mechanisms of market discipline. However, the situation also highlights the demand-side constraints in terms of financial literacy and consumer protection.

Our conclusion from the recent crisis, therefore, is that it has not reduced the importance of financial sector deepening and broadening for inclusive economic growth in Africa. The financial sector challenges in (i) expanding access to financial services, (ii) lengthening financial contracts and (iii) safeguarding financial systems, however, are not new. Africa’s informality, lack of scale, volatility, and governance problems have been discussed extensively. Not new either is a long list of solutions that have been tried on the continent in one form or another. Many solutions have been discredited in one decade only to become the flavor of financial sector reforms in the next. Yet the challenge of limited and costly finance in Africa persists. Even when solutions are being implemented in other continents today, their transplantation to and application in Africa is not taking place at a rate sufficient to make a substantial and sustainable impact on the availability of affordable finance.

We argue that the problem has not been in the choice of the ‘solutions’ but rather, the direction and quality of their application to Africa’s local circumstances, and the failure to build or scale up home grown solutions. We also caution that unless there are changes in the politics of financial reforms in Africa, even the recent opportunities of globalization, technology and regional integration will suffer the same fate as others that once promised to resolve Africa’s financial constraints.

While modernization represents the bedrock of any credible vision for national financial sectors, whether in Africa or elsewhere, we think that the problem has been the application of the modernist agenda on the primary premise that modernization is equivalent to “best practice” of the advanced market economies. Unless policymakers and development partners that work with them deliberately redefine progress in financial sector development to suit local African conditions, the modernist agenda will continue to overreach in Africa. In the end, all financial sector policy is local.

The politics of financial sector reform in Africa

The short-term election cycle of African politics is at natural odds with the long-term nature of financial sector development and reform. So are the plethora of politically convenient financial sector policies and programs that are incompatible with market-based financial sector development. Instead, the political realities call for the design and development of second best solutions which go beyond the pre-occupation with unachievable ‘optimal’ policies and take these governance realities into account more systematically. First, seek out incremental reform options that are feasible given political economy realities. Second, draw on knowledge of economically ‘optimal’ policies in the design of reform. Third, consider options for strengthening institutions

The three overarching messages of this flagship report are closely related to the discussion on the politics of financial sector reform. One important effect of financial sector deepening and broadening is the increase in competition and contestability throughout the economy. New players, new markets and new products undermine the rents of the incumbents, not only in the financial sector, but throughout the economy. Pushing a financial system beyond banks towards new providers and products will also generate resistance from incumbent financial institutions, most prominently from banks. A critical role—and here we link to our third message—has to be played by a constituency for financial sector reform. Small enterprises and previously unbanked segments of the population constitute the potential beneficiaries. In the long-term it is thus critical to create a constituency for financial sector reform, which comprises the beneficiaries of further broadening financial services. Financial literacy can also be important in this context and financial journalists can play an important role.

What is the role of regional integration?

Regional integration can help reduce the scale diseconomies stemming from the fixed costs in financial service provision and the fact that most African economies are small. The scale economies of regional integration can be reaped at the level of financial institutions, such as multinational banks, and at the level of financial markets through regional and cross-listing arrangements. However, they can also be reaped at the level of financial infrastructure, including payment systems, credit registries and even the regulatory and supervisory framework.

What are the practical steps to regional integration? One size does not fit all. Some parts of Africa, most prominently the currency unions of Central Africa and West Africa, already have structures in place that can be used to advance integration. In other parts of Africa, most prominently East Africa and southern Africa, there is political impetus for more regional integration. We argue that much can still be achieved without waiting for political integration by focusing on (i) private-sector-led efforts such as through regional banks, (ii) technical harmonization in regulation, (iii) physical standardization of financial infrastructure, such as payment systems, and (iv) upgrading of information and communication technology.

A challenging agenda

The challenges of (i) expanding access to financial service, (ii) lengthening financial contracts and (iii) safeguarding financial systems require a joint effort of many stakeholders, including the private sector, regulators and donors. The challenge for regulators is to achieve stability, while pursuing financial deepening and inclusion. Our findings suggest that regulators should pursue a holistic approach to financial sector reform that begins with a change in perceptions about financial institutions, products and services in Africa and, subsequently, a change in policies, legislation, regulations and supervisory practices. Critically, more space has to be given to the private sector to introduce the necessary innovations to deepen and broaden financial systems in Africa. Globalization, regional integration and technology will create new challenges for financial sector regulators. Globalization and regional integration will require home and host country regulators to cooperate more closely in regard to crossborder banks, and these home and host countries will increasingly be outside the developed world. Technology, especially in mobile financial services, will require closer cooperation among regulators across sectors, but also a more agile regulatory approach.

Similarly, development partners must adopt an equally different approach in the way they provide technical assistance for financial sector reforms in Africa. First, there must be greater selectivity and more careful application of best practice models across heterogeneous African countries, taking into account different country characteristics and experiences. Second, development partners should pursue more policy-based assistance. Finally, development partners should continue to invest in the capacity development of country authorities and regulators to enable them to implement policy, safeguard financial sector growth and create an enabling environment that motivates innovation and ensures stability. Ultimately, financial sector deepening and broadening has to be driven locally.

Africa’s financial systems are on the move. There is a lot to be gained. There is ample evidence that deeper and broader financial systems can help African move out of poverty. Accepting the opportunities that globalization, regional integration and technology offer can result in steeper growth trajectories. However, these opportunities require a re-definition of the roles of the private and public sector as well as of donors. They require looking beyond the dichotomy of modernist and activist approaches towards an approach that recognizes that all financial sector policy is local! Reaping the benefits of these opportunities requires recognizing the politics of financial deepening and creating constituencies for financial sector reform. Financing Africa demands looking beyond the crisis towards the structural challenges and opportunities the continent offers.