Authors: Albert-Eneas Gakusi, Henry Bagazonzya
Site of publication: Making Finance Work for Africa (MFW4A)
Type of publication: Article
Date of publication: April 27th, 2022
De-risking and trade finance
The environment in which African financial systems operate has changed significantly in recent years. The global financial crisis in 2008/09 heightened attention to the interactions and trade-offs between financial sector development and financial stability, and to the links between the financial systems and the real economy. A negative effect of much of the new financial regulation that the G20 ushered in under the Basel III regulatory framework focused on increasing capital buffers in rich countries’ banks, which resulted in developed countries’ banks withdrawing capital from emerging markets, including Africa.
This situation also led to a reduction in correspondent banking relationships, with a focus on perceived high-risk jurisdictions, which included Africa. This de-risking had significant effects on trade finance, which led the African Development Bank (AfDB) to put in place the trade finance initiative in 2009 to respond to these negative effects. This initiative was replaced by Trade Finance Program (TFP) in 2013. These changes meant that access to finance was hindered by more stringent international regulations and stronger prudential control, including minimum capital, anti-money laundering and combating the financing of terrorism (AML/CFT) requirements, among others.
Low Level of Access to Finance
While there has been substantial progress over the past decade, access to finance continues to be a key constraint for firms in Africa, particularly for small and medium enterprises (SMEs). Recent available information indicates that 82.6 percent of formal Micro, Small and Medium Enterprises (MSMEs) in Africa have unmet financing needs. This finance gap was 41 percent for all developing countries.
Recent available information indicates that 82.6 percent of formal Micro, Small and Medium Enterprises (MSMEs) in Africa have unmet financing needs. This finance gap was 41 percent for all developing countries
SSA also lags behind other regions in access to finance, with only 19.9 percent of firms having a bank loan or line of credit in 2020. Despite an increase from 34 to 43 percent between 2014 and 2017, the percentage of adults with an account in SSA and Middle East and North Africa (MENA) was the lowest compared with the other regions. However, SSA outpaced MENA for access to finance for the female population and it achieved far better access than the other regions for which information is available for the use of mobile money.
Use of long-term finance—frequently defined as financing for a tenor exceeding one year—is more limited in developing countries, particularly among smaller firms and poorer individuals. Where it exists, the bulk of long-term finance is provided by banks; use of equity, including private equity, is limited for firms of all sizes. Furthermore, the global financial crisis of 2008/09 led to a reduction in leverage and use of long-term debt for firms in developing countries. SMEs in lower middle-income and low-income countries were particularly affected, witnessing a reduction in both their leverage and the use of long-term debt. Large firms in developing countries that are able to access financial markets were affected given that they relied on international markets to a greater extent than their counterparts in high-income countries. Such firms were also more vulnerable to the large drop in syndicated lending during the crisis.
Several policies aimed at promoting long-term lending have generally been unsuccessful. This is because: (i) the underlying institutional problems and market failures that underpin the low use of long-term finance have remained; and (ii) political capture and poor corporate governance practices have undermined the success of direct interventions by governments. What is required is that governments need to focus on fundamental institutional reforms, including: (i) pursuing policies that promote macroeconomic stability, low inflation, and viable investment opportunities; (ii) promoting a competitive banking system with healthy entry and exit, supported by strong regulation and supervision; (iii) putting in place a legal and contractual environment that adequately protects the rights of creditors and borrowers; (iv) fostering financial infrastructure that limits information asymmetries; and (v) laying the necessary institutional and incentive frameworks to facilitate long-term development of capital markets and institutional investors. Well managed development banks and capital markets can help catalyze private flows and channel them to inclusive and sustainable development. So far, there is a lack of depth and liquidity in most of Africa’s capital markets. Individual capital markets are not integrated, and there is very low participation of SMEs within the capital markets ecosystem.
Regional and National Development Banks
There has been a renewed interest in national and regional development banks since the 2008/9 financial crisis. Recent research asserts that development banks provide long term financing, may contribute to systemic stability and help develop and deepen financial markets, among other roles. The Third United Nations International Conference on Financing for Development adopted a comprehensive policy framework, which underscored the potential role that well-functioning national and regional development banks can play in financing sustainable development, particularly in credit market segments in which commercial banks are not fully engaged and where large financing gaps exist, based on sound lending frameworks and compliance with appropriate social and environmental safeguards.
Regulatory and Supervision Capacity
Developments in the financial sector over the past decade have put pressure on regulators, especially when new players have entered the financing space. One of the constraints that has been observed during the period is that regulators and supervisors lack the capacity and resources to keep up with market developments, and to oversee the increasing complexity in the financial sector. The financial sector reforms that have been implemented in Africa during the past decade have led, for example, to the increase of Pan-African banks, which have driven homegrown financial sector development, but also overstretched the supervisory capacity of home and host countries, and added complexity to the oversight process. Governments, and regulatory and supervisory authorities are being challenged to set up and enforce legislation and implement regulations.
So far, there is a lack of depth and liquidity in most of Africa’s capital markets. Individual capital markets are not integrated, and there is very low participation of SMEs within the capital markets ecosystem
Traditionally, regulators were focusing on deposit-taking institutions to prevent them from losing depositors’ funds and to prevent systemic risks in the financial sector. However, the emergence of new business models enabled by digital technology and the diversification of financial services have put further pressure on regulators and supervisors. Those business models often cross the boundaries of traditional financial services, and require strong cooperation between regulators and supervisors from the financial, telecommunications and other parties involved in provision of financial services like Fintechs. With regulatory and supervisory resources already limited, governments tend to take a rather restrictive approach, which limits innovation, but may protect financial stability.
Coronavirus and Its Implications for the Financial Sector
The outbreak of the COVID-19 pandemic in early 2020 has resulted in economic recession and aggravated the already daunting difficulties to support the financial sector. According to the IMF, the pandemic threatens to exact a heavy human toll and the economic recession triggered can up-end recent development progress. Governments are pursuing various mitigation measures, which include increased public health expenditure, fiscal policy measures to support cash transfers, and monetary policy intended to support commercial banks and other financial service providers to continue to provide needed financing and other support to firms to maintain their operations.
Overall, however, the crisis has increased government debt, while at the same time hurting many businesses, and causing much higher levels of unemployment and lower sales in most sectors. This leads to debt service problems, surging non-performing loans (NPLs) and problems in the financial sector that threaten liquidity and solvency. Muazu Ibrahim (2022) has calculated that: “The number of African countries breaching the IMF debt–to–GDP threshold of 55 percent rose from 28 in 2019 to 30 in 2020. Similarly, the number of countries breaching the African Union Commission debt–to–GDP threshold of 70 percent significantly rose from 14 to 20.” International financial institutions (IFIs) had to increase their support to governments and financial institutions (FIs) to mitigate the effects of COVID-19 and during the economic recovery. Among the non-resource-intensive countries, those that depend on tourism have witnessed a severe contraction because of extensive travel restrictions and lockdowns, while emerging market and frontier economies will face the consequences of large capital outflows and tightening financial conditions.
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