FSAP’s in Africa

Common Issues & Lessons

Ann Rennie

December 2003

Background

What is the financial sector assessment program (FSAP)? Commenced in 1999 in wake of Asian crisis Joint IMF/WB initiative with 75+ cooperating

institutions 90 + FSAPs conducted to date

(OECD,emerging and IDA) Voluntary; Results confidential

The FSAP program seeks to…

Identify strengths & vulnerabilities

Assess overall soundness and stability

Highlight linkages between macroeconomy & financial sector

Ascertain development and TA needs

Make policy recommendations

Building blocks

Assembly of data on system functioning Including scale, liquidity, efficiency, reach, exposure

Interviews with market participants Standards and codes assessments

Detailed structured discussions with authorities

Formal stress-testing

Overall assessment

Codes are selected from…

Basel Core Principles for Effective Banking Supervision (BCP)

Transparency (Monetary & Financial Policies) Systemically Important Payment Systems (CPSIPS) Securities Regulation (IOSCO) Insurance (IAIS) AML-CFT (FATF)

Other: Accounting & Auditing; Corporate Governance; Insolvency and Creditor Rights

Frequency of codes assessed in FSAPs

0 20 40 60 80 100

AML

IAIS

IOSCO

CPSIPS

MFPT

BCP

Percentage

to Dec 2002

Average codes assessed : 4.9 (3.6 for Africa)

Issues in code assessments

Not all relevant codes can be covered Need to be supplemented by less formal work

Cross-sectoral issues Interaction between different sectors Regulatory overlap or underlap

Coverage gaps e.g. contractual savings/social insurance

(financial sector aspects); deposit insurance

Codes are developed by regulatory bodies and reflect their partial focus

Mechanical code diagnosis may miss national features

Excessive focus on good “ratings”

Issues in Code Assessments

Gaps in standards

No standards for key stability & development issues such as: Macrofinancial crisis management Competition environment, Tax, quasi-tax and subsidy issues Access to financial services Missing markets Overall legal framework

The future: less reliance on full code assessments Certain aspects of detailed assessments may be

inapplicable in small, less developed systems

Attempt to retain enough of the essence of the code without excessively detailed questioning or ratings

Select only most relevant codes and transfer additional resources to specific country needs

Stress Tests: Crisis Prevention & Prediction

Can FSAPs predict a crisis?

Is the system in “Zone of vulnerability”?

Identifying likely channels of vulnerability

Crisis management mechanisms

Stress Testing

Look at sectoral pattern of lending, market portfolio.

Must be bank-by-bank: averages can conceal

The essence: recalculate bank’s capital after shock

Impact of shock on loan performance usually judgmental

Stress testing

Typical shocks: exchange rate, interest rate, liquidity, commodity prices, housing prices, quality of loan classification

Scale of shocks: historical data Correlations: usually scenarios(More elaborate procedures used for some advanced

economies)

(mainly banking system)

Developmental Aspects

Market Infrastructure for Access Collateral and bankruptcy laws; competent and impartial

courts; information infrastructure (e.g. accounting and auditing, rating agencies, credit registries)

Monopoly Power and Related Distortions Detecting evidence of market power Positive and negative policy

Nonbank Intermediaries & Organized Markets Entry and legislative environment Minimum scale issues and globalization

Aspects of the development dimension

Special Institutions for AccessE.g. development banks, microcreditIssues include subsidies, burdensome regulation

Taxation of Financial Intermediation Distorting or inhibiting subsectors or key

instruments

The Demand SideAssessing unmet needs of corporates &

households (not easy)

Outputs

Aide Mémoire Working document, not for publication

FSSA (IMF Board) Financial sector stability assessment

FSA (WB Board) Financial sector assessment

Technical Notes on selected issues

Detailed standards & codes assessments

ROSCs Summary report on observance of standards & codes

SSA Countries Assessed (13)

Cameroon Cote d’ Ivoire Gabon Ghana

(+update) Kenya Mauritius Mozambique

Nigeria Senegal South Africa Tanzania Uganda Zambia

Common Issues

Generally small, bank-dominated financial systems Credit risks substantial : high risk concentrations, high

level of NPL’s, problems with contract enforcement and loan recoveries

History of state ownership & intervention in FI’s—though evolving to private ownership

Intermediation margins are high Access to financial services is limited Macroeconomic stability remains a problem in several

countries Vulnerable to external shocks: commodity prices, FX

rates, donor funding

M2/GDP

0102030405060708090

% o

f GDP

0.0% 50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

South Africa

Mauritius

Zambia

Uganda

Tanzania

Senegal

Ghana

Nigeria

Gabon

Cameroon

% of GDP

Banks

Insurance

Other NBFI

Pension

Microfinance

Structure of the Financial System

Role of the State

Potential conflicts of interest: state as shareholder, regulator, borrower, depositor

High, though diminishing, state ownership in a number of countries (banks, insurance, DFIs) Many costly failures: high NPLs, poorly

governed, overstaffed, inefficient Directed lending to meet political,

development, and patronage objectives

Issues in Regulation & Supervision

Focus on formal compliance (check box approach); insufficient attention to quality of management, governance, risk management and internal controls

Lack of adequate enforcement powers or unwillingness to use powers

Lack of effective independence Regulatory forbearance Poor information exchange with domestic and

foreign supervisors

Regulation & Supervision -recommendations

Strengthen licensing procedures, applying strict “fit and proper”criteria

Assess both quantitative & qualitative factors Adopt proactive approach, acting preemptively upon

detecting increased risks Adopt risk-based approach, focusing on riskiest areas

and institutions Act promptly to resolve FI’s to preserve stability and

minimize resolution costs Ensure accurate and timely information disclosure Ensure accountability of shareholders, Boards of

Directors, and senior management

Limited Access to Financial Services

In most African FSAP countries, <10% of the population has a bank account

Banks typically limited to large cities due to high costs/low returns of maintaining large branch networks

Credit often restricted to a small set of established corporate borrowers due, inter-alia, to legal & judicial weaknesses

Rural Finance

Challenges

Dispersed populations; poor transport & communications> high cost of delivery

High risks associated with rain-fed agriculture & commodity price fluctuations

Land tenure systems which limit value of land as collateral

History of state subsidized lending & low recoveries

Development Finance Institutions

Public Development Banks have poor track record: Poor governance, political interference in

lending decisions Poor financial performance Do not overcome market failures or promote

development History of costly failures of DFIs

Microfinance Degree of development varies widely, but growing

rapidly Outreach exceeds that of banking systems in several

countries, though remains small in terms of total assets

Credit unions, NGO-sponsored credit-only MFIs predominant models

Group lending & character-based techniques often used to achieve high repayment rates

Sustainable, commercially viable institutions extremely rare

Countries searching for appropriate regulatory framework

Microfinance: recommendations Financial Systems Approach

Wide range of providers (regulated & non-regulated)

Serving diverse clientele with variety of instruments and services

Integration into commercial financial system necessary to achieve sustainability and large-scale outreach

Light and flexible regulatory approach required , particularly in early stages of development

Regulation & Supervision of MFIs No agreed standards — early days — but

pragmatism advised:Regulation & supervision have significant costs

Need to distinguish between non-prudential and prudential regulation

May be unwise to burden bank supervisors with

responsibility for a large number of small institutions they cannot effectively supervise

Regulation & Supervision of MFIs

Small, community-based intermediaries should not necessarily be barred from taking deposits simply because they are too small or remote to supervise effectively—may be less risky than alternatives (cash, livestock)

Authorities should not try to dictate particular form/s of institutional development

Interest rate caps are inappropriate to microfinance Credit-only NGO MFIs do not need to be regulated Politically-directed, government subsidized credit programs

may contaminate the environment for non-government MFIs “Benign neglect” may be a viable and practical alternative to

active regulation & supervision in early stages of development of microfinance

Recommendations to improve access

Address legal, regulatory and judicial weaknesses

Foster competition and diversity in the financial system

Develop credit information systems

Use technology to increase outreach at a reasonable cost

Contractual Savings

Life insurance and pension funds play key role in financial sector development: Mobilization of long term resources Major investors in capital markets Provide funding for other NBFI’s (leasing, factoring, housing finance)

But contractual savings relatively undeveloped in most African countries (South Africa, Mauritius are notable exceptions)

Insurance

Insurance penetration is generally low (1-2%), and dominated by general insurance (auto)

Public sector ownership has caused poor performance in many countries.

Controls on premiums, investments, and reinsurance have hindered development

Despite high concentration ratios, many markets overpopulated and highly competitive with many small, under-reserved companies with high expense ratios

Regulation & supervision often weak

Insurance-Common recommendations

Strengthen regulation and supervision under an independent supervisory authority

Privatize remaining state-controlled companies Promote industry consolidation where appropriate Increase minimum capital and tighten licensing

requirements Close weak companies which are unable to

implement a time-bound remedial action plan Lift unnecessary controls on premia, investments

and re-insurance

Pensions

Public funds dominate, though South Africa, Mauritius, and Kenya have well-developed private pillars

Many schemes face rising & unsustainable deficits Investment returns weak or negative:

Government directed investments Illiquid real-estate investments Maturity mismatches Absence of international portfolio diversification Lack of investment opportunities & investments

Low coverage—typically <10% of labor force High administrative expenses

Recommendations: Pensions Fundamental reform of public systems required

to ensure long-term sustainability Shield fund governance from political

interference Promote professional asset management and

allow international diversification Improve administrative efficiency: actuarial

forecasting, record-keeping, collection, etc. Encourage greater private provision of pensions Strengthen regulation and supervision

Challenges for capital market development in Africa

Limited size and high levels of concentration in terms of both participants and trading

Limited activity levels and lack of critical mass to support market services

Lack of market facilities, infrastructure and services (including know-how)

Challenges for capital market development

Scarcity of investment capital (may be exacerbated by migration of capital and issuers to regional and global markets)

Inadequate legal and regulatory environment to support credible markets (including enforcement and judiciary)

Successful Capital Markets Economic viability: the market covers its costs and

ideally earns a return on the owners’ investment Organized central market: provides trading,

settlement and market information systems required to support a transparent market, effective price discovery and access to issuers and investors in accordance with a clear set of rules and standards.

Appropriate levels of investor protection and market integrity.

Meets the needs of local investors, issuers and intermediaries at a reasonable cost.

Successful Capital Markets

Small nascent markets do not require sophisticated trading, information, clearing and regulatory systems comparable to those required in large developed markets.

Need to tailor features to current levels of activity and the needs of local market participants

Alternatives to stand-alone national stock exchange

OTC market

Purchase facilities

Outsource operations

Regional exchange or Alliance of markets

Subsidiary (or merger) of larger market

Lessons from successful small markets Start out small

Have realistic expectations

Grow market services and regulation organically in tandem with the market

Use new technology only if direct and indirect costs are low

Don’t over-regulate (it’s costly)

Lessons from successful small markets

Don’t rely on equity markets to cover fixed costs. Many successful markets in the early years relied heavily on revenues from fixed- income products.

Cost/Benefit Analysis