FSAP ’ s in Africa

1. FSAP’s in Africa Common Issues & Lessons Ann Rennie December 2003

2. 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

3. 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

4. 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

5. 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

6. Frequency of codes assessed in FSAPs Average codes assessed : 4.9 (3.6 for Africa) to Dec 2002

7. 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

8. Issues in Code Assessments • Codes are developed by regulatory bodies and reflect their partial focus • Mechanical code diagnosis may miss national features • Excessive focus on good “ratings”

9. 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

10. 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

11. 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

12. 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

13. Stress testing (mainly banking system) • 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)

14. 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

15. Aspects of the development dimension • Special Institutions for Access • E.g. development banks, microcredit • Issues include subsidies, burdensome regulation • Taxation of Financial Intermediation • Distorting or inhibiting subsectors or key instruments • The Demand Side • Assessing unmet needs of corporates & households (not easy)

16. 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

17. Cameroon Cote d’ Ivoire Gabon Ghana (+update) Kenya Mauritius Mozambique Nigeria Senegal South Africa Tanzania Uganda Zambia SSA Countries Assessed (13)

18. 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

19. M2/GDP

20. Structure of the Financial System

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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)

33. 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

34. 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

35. 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

36. 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

37. Challenges for capital market developmentin 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)

38. 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)

39. 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 levelsof investor protection and market integrity. • Meets the needs of local investors, issuers and intermediaries at areasonable cost.

40. 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

41. 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

42. 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)

43. 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.

44. Cost/Benefit Analysis