Financial Sector Trends in EMDEs: Financial sector risks are divided along income lines

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Financial Sector Trends in EMDEs: Financial sector risks are divided along income lines Photo by Ekrulila from Studio Turkey

The financial sector risk outlook in emerging market and developing economies (EMDEs) is a tale of opposites.

While financial sector risks for most higher-income EMDEs are relatively low, half of lower-income countries (LICs) face high risks in the next 12 months that, if materialized, could threaten domestic financial stability. In fact, almost 9 out of 10 countries facing high risks are lower-income EMDEs.

In many EMDEs, the financial sector outlook is strongly influenced by monetary policy developments in advanced economies, where interest rates continue to hover near the highest levels seen in decades and the timing and extent of monetary easing remains uncertain. The recent intensification of geopolitical conflicts and tensions has the potential to cause new spikes in global energy and food prices, leading to renewed inflationary pressures and tighter financial conditions for longer.

While most large EMDEs have been able to moderate the impact of high global interest rates, many lower-middle income countries (LMICs) and LICs face substantial challenges such as currency depreciations, rating downgrades, and higher borrowing costs due to higher rates.

In a striking example of financing challenges in lower-income EMDEs, countries in Sub-Saharan Africa found themselves completely excluded from international debt markets for most of 2022 and 2023. And private sector debt issuance slowed in 2022 and 2023 across all EMDEs and nearly dried up completely in LMICs, where it plummeted 57 percent in 2023 from the previous year.

Retrenching foreign investors and a narrow domestic investor base in lower-income countries often leave domestic banks as lenders of last resort, and governments have encouraged them to purchase sovereign debt. As a result, EMDE banks’ average exposure to the government as a share of bank assets rose by 35 percent between 2012 and 2023. This so-called sovereign-bank nexus dangerously intertwines fiscal and financial sector health and presents a major risk to banking sectors in several lower-income EMDEs. Such spillovers from sovereign risk to the domestic banking sector already materialized in recent years in Ghana, Sri Lanka, and Lebanon, and more countries could follow.

Despite this challenging backdrop, analysis suggests that banks in EMDEs are generally sound and resilient. There are, however, pockets of weakness. Again, these weaknesses are concentrated in lower-income countries. Whereas most banks in larger EMDEs appear to have sufficient capital buffers to withstand a shock, a significant number of banks in lower-income countries would be undercapitalized if confronted with a significant but plausible 5-percentage-point increase in the nonperforming loan ratio.

Several banks—mostly in the Middle East and North Africa, Sub-Saharan Africa, and South Asia regions—are also highly vulnerable to risks of “haircuts” on government bonds resulting from possible debt restructurings, which could affect their financial stability and viability.
 

Fortifying Vulnerable Financial Sectors and accelerating development

Concerningly, EMDEs with the highest financial risks are also the least prepared to prevent crises. Almost seven in ten EMDEs with highly vulnerable financial sectors lack a strong financial sector policy framework and institutional capacity to handle financial stress.

 

Regulatory tools exist to address these challenges, and reforms in more resilient EMDEs have shown the importance of sound supervision and strong financial sector safety nets to fortify financial sectors.

Measures needed to fortify financial sectors in highly vulnerable EMDEs include:

  • Strengthening the mandate, independence, and powers of banking supervisors
  • Addressing weaknesses in banking supervision and improving the reporting and resolution of nonperforming loans in a proportional manner
  • Ensuring a robust legal and institutional framework of debt resolution and corporate and household insolvency
  • Addressing gaps in crisis management frameworks
  • And improving the coverage, funding, and operational readiness of deposit insurance systems.

In addition to strengthening financial sector resilience, policy makers in EMDEs should also focus on developing their financial sectors so they can better serve the needs of the real economy and work toward ending poverty on a livable planet. Financial development matters: supported by sound policies, institutions, and infrastructures, countries with more developed financial systems can better allocate capital and risks and enjoy higher, more sustainable economic growth and larger reductions in poverty and income inequality.

Supported by the spread of digital financial services, there has been improvement in financial inclusion at the individual level as well as in greening of the financial sector. But many other development priorities such as increasing access to finance for small firms, deepening capital markets, and promoting competition and efficiency saw more limited recent progress. An acceleration of efforts is urgently needed to unleash the potential of financial sectors to support economic development.

There is much more about EMDE financial sector trends, risks, resilience, and development in the recently published Finance and Prosperity 2024 Report.



Nepomuk Dunz

Financial Sector Economist

Erik Feyen

Head Global Macro-Financial Monitoring and Lead Financial Sector Economist

Fiona Stewart

Lead Financial Sector Specialist

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