Forecast: Bank failure to hit Africa

AFRICA, through drastic banking sector overhauling initiatives may indeed recover all, including her debased economy and soon turn around her fortunes to become the world's fastest growing economy, alleviating and gradually eradicating acute poverty from her landless and unemployed masses. Millions of Africa's economically marginalized populace today, face hunger and starvation caused mainly by bad governance buttressed by transient ill-climatic changes resulting in little to no rainfall at all.  Negative monetary policies and discriminatingly oppressive government investment drives are considered as major factors that will be responsible both for bank failures and X-inefficiency not in the so distant future. Nowadays, the African banking sector is composed of four main groups: state-owned banks (SOBs), large and medium-size private banks, foreign banks, and so-called indigenous nicknamed "dwarf" banks.

Africa has of late been plagued by weak banks due to the interference of the state's central banking policies which are limitative to bank growth. Weak banks are however a worldwide phenomenon. But if ever there is going to be meaningful economic recovery in most African states, African governments should be ready to deal robustly with their respective banking sector policies.  This report provides a toolkit offering practical guidance in the areas of problem identification, corrective action, resolution techniques and exit strategies.

It is also commonplace that moral hazard from the part of bank owners shall also be top among the reasons why banks will soon be officially declared bankrupt in most African states. The captiveness or affiliation of a bank with a financial-industrial group will in the future exaggerate the adverse effects on failure caused by primary factors such as a high level of foreign debt. In some sense, more captive banks will be more "willing" to fail ceteris paribus, consistent with the abundant anecdotal evidence about tunneling and asset stripping.

There is need for African regimes to restructure the banking sector, and that they ought to consider it as one of the most important prerequisites for the successful establishment of sustainable economic growth in Africa. By its nature, a commercial bank is a fragile institution since its liabilities, deposits, are typically liquid but most of its assets, loans and securities, are illiquid. This implies that a bank is prone to runs by depositors. In real life, a bank is an opaque institution: the structure and quality of its loans is unobservable by outsiders. That is why even healthy banks may even fail in Africa's economic uneven terrain. This may induce unknown fear in bank owners and so result bank panics: if an owner of bank A learns that bank B has been ruined he or she may prefer shut his or her bank from African country A just to be on the safe side.

From the economic perspective, the main function of a commercial bank is the transformation of clients' deposits into loans to enterprises and households. This implies that the banking "technology" can be described in terms of production function where deposits, labor, purchased funds, and physical capital enter as inputs while loans and securities enter as outputs. However, a bank affords its production possibilities frontier if and only if its manager does all his best on his job. At the same time, the incentives of the bank manager not always go in line with the incentives of bank owners. This may result in X-inefficiency of the financial institution.

Depositors are likely to gradually develop an inherent bad faith in the banking sector which over-regulated by government such the survival of a bank becomes uncertain. For fear that a bank may wake up tomorrow bankrupt, depositors' capacity to entrust their monies to banks in that particular nation drastically shrinks to almost zero. Indeed, it is hard for an uninformed depositor to judge whether a shock that hit banking sector of country B is systemic, sector-wide or economy-wide, for example, due to government financial and investment policies, or idiosyncratic, banking sector of country B specific, for example, or that it might have been caused by the bank's incompetence.

Most banks in many African nations are weakening whether they be traditional or online banking systems. Thus this fragility of banks is likely to give rise to a need for the prudential supervision, which implies that a supervisory authority, often the central bank is responsible for monitoring financial institutions and withdrawing licenses from those of them that get insolvent and threat therefore the stability of the whole sector. The central bank or other supervision authority is thus supposed to eliminate the possibility of information based runs. The central bank however may need some quantitative information for the identification of problematic banks on earlier stages before they contaminate other institutions, for example, through failure to repay interbank loans or deliver forward contracts.

Africa will be hit a bank management crisis and issues such corruption and money laundering will continue to bedevil most banking sectors in most African states. Poor quality bank management, shall be on the other hand, among primary factors of bank failures. So our main hypothesis is that banks that are over regulated by government and also badly managed are more likely to go bankrupt.

There is need for African governments to relax banking sector legislation and policy in order to create a 'laissez-faire' banking atmosphere that allow banks to grow in a naturally healthy and balance state. This will allow the banking sector to assume its integral role of being one among the major contributors of economic development and poverty alleviation in African societies. According to the modern view, banks perform four basic functions in an economy (Freixas and Rochet 1997). First, they transform assets by intermediating funds from savers to productive users. Second, they offer an access to a payment system by delivering settlements among economic agents. Third, they manage risks. Finally, they monitor borrowers and process information about borrowers. The "intermediation" approach (Sealey and Lindley 1977, Berger and Humphrey 1991) emphasizes the first function and implies that loans and non-loan financial investments can be treated as bank outputs whereas deposits along with labor, physical capital, and borrowed funds — as bank inputs. One could therefore describe a banking technology using a conventional cost function. The argument list of the cost function would include the vector of bank outputs, the vector of factor prices and, perhaps, some other relevant variables. According to a textbook definition, the value of the cost function is equal to the minimum level of costs sufficient to produce a particular output mix for given factor prices.

However, most banks in Africa are likely not going to operate at the minimum cost level due to some problems caused by asymmetric information. Lack of expertise, excessive risk taking, and shirking can be possible explanations of poor performance. In other words, as soon as the effects of information asymmetries are taken into account, one could expect that the actual cost of a typical bank is higher than its efficient level prescribed by the cost function, which is referred in the literature as the "best-practice" frontier. This kind of inefficiency is called X-inefficiency. In general, X-inefficiency is defined as the peculiar form of inefficiency that arises for organizational reasons rather than technological reasons when the interests of managers and workers are not perfectly in line with those of bank owners (Leibenstein 1966).

Informing government policy toward financial institutions shall be imperative and an important application of bank efficiency measurement. Fukuyama (1995) investigated the question how the bursting of the speculative bubble in Japan influenced the efficiency of Japanese banks. He found little effect although the bad loans it created clearly had a significant adverse effect on Japanese banks. Another strand of the literature investigates the link between bank failures and inefficiency. Most bank failures are directly related to having a large number of problem loans, a low capital position, a weak or negative cash flow, and a poor quality of management. One can expect that financial institutions display lower efficiency prior to their failures.

A straightforward application of traditional techniques to the African case seems somewhat incautious given the peculiarities of the African transition economy, business and regulatory environment in the sector. The conventional methodology needs to be adjusted. We therefore propose that a number of technical policy adjustments in the methodology of African banking have to be made on the empirical stage, as matter of continental developmental priority.

Most African states own shares in financial institutions, including blocking stakes (shareholdings exceeding 25% of common equity) in most commercial banks. Virtually all of these institutions are universal banks by their nature, meaning that they offer a full range of bank services to their customers.

Almost all segments of the market for financial services are dominated by the State Owned Banks (SOBs). This is going to threaten the future prosperity of Africa's banking sector. There will be at least two problems with SOBs. First, in many cases, they will continue to either channel government funds to the so-called "strategic" industries, such as agricultural sector and military industry, or grant loans guaranteed by the government to the same "strategic" borrowers. In other words, these banks play a rather technical role in the allocation of funds, which does not require from them a comprehensive risk assessment and monitoring borrowers. Second, SOBs will continue to often enjoy unfair competitive advantages, such as government and/or Central Bank finance and the privilege to be bailed out in the case of emergency.

Summing up, many SOBs are virtually financial branches of the African regime governments rather than actual financial intermediaries. It follows that the motivation of their managers is likely to differ from the motivation of managers of financial intermediary. For example, they might pursue empire building activities or just shirking rather than cost minimization and monitoring risks. Hence, representing the technology of these banks in terms of cost function, in principle, may be misleading. It should be said, however, that many of them are just "pocket banks". In many cases, such banks function primarily as treasures for their holdings, so that their role as true financial intermediaries seems rather limited. The large "pocket" banks, like many SOBs, tend to limit lending of external, i.e. independent from a mother FIG, borrowers. They only re-distribute funds mainly in line with government controlled initiatives, on a command basis. This may result in a distorted motivation of their managers and "non-conventional" cost function.

In addition, a higher percentage of assets in most African states are controlled by foreign banks. Many of them act as independent financial intermediaries attracting deposits from savers and granting loans to investors. This segment, apart from (SOBs), is believed to become a growing point of Africa's banking industry. At present, a lot of foreign-owned banks do business in Africa. They concentrate primarily on servicing foreign trade, and their activities include settlement services, short-term trade loans, and foreign exchange transactions. Foreign-owned banks will continue to pursue rather conservative business strategies and prefer not to expand their operations in Russia too rapidly. Since 1999 the share of foreign banks in the sector's equity has dropped from 13.5 to 5.3% in the case of Zimbabwe.

The most numerous group comprises numerous indigenous banks, which control no more than 10% of total assets in Africa. It is not clear in what kind of business these banks are engaged in most cases. The most common view is that the main source of their earnings consists of fees for various "grey" services, e.g., money laundering, illegal exports of capital, tax evasion, etc. It is often argued that a simultaneous closure of all these banks will more likely benefit rather than hurt the economy.

The African banking sector is extremely heterogeneous and set to boost if the necessary corrective steps are immediately put into practice. Many financial institutions in Africa currently concentrate on activities that have nothing to do with financial intermediation. This implies that a set of proxy variables assigning a bank to a particular segment or class may have a considerable explanatory power. Another point is that largest banks might explore a kind of rent due to their ability to influence on policy decisions (e.g., obtaining a stabilization loan on favorable conditions), get access to private information (e.g., timing interventions on the foreign exchange market), etc. Hence, a variable capturing the political influence of a particular bank, e.g., the bank size or top 30 banks dummy, seems worth including into an econometric model.

In retrospect we study that in the 1980s and early 1990s several countries, including developed economies, developing countries, and economies in transition have experienced severe bank failures. Such proliferation of large scale banking sector problems has raised widespread concern, as bank failures disrupt the flow of credit to households and enterprises, reducing investment and consumption and possibly forcing viable firms into bankruptcy. Banking crises may also jeopardize the functioning of the payments system and, by undermining confidence in domestic financial institutions; they may cause a decline in domestic savings and/or a large scale capital outflow.

In a nutshell, harsh investment policies are likely to impede direct foreign investment in most regimes-governed African states a move that if not fast-abated may force sound banks to close their doors. In most countries policy-makers have attempted to shore up the consequences of bank failures through various types of intervention, ranging from the pursuit of a loose monetary policy to the bailing out insolvent financial institutions with public funds. Even when they are carefully designed, however, rescue operations have several drawbacks: they are often very costly for the budget; they may allow inefficient banks to remain in business; they are likely to create the expectation of future bail-outs reducing incentives for adequate risk management by banks; managerial incentives are also weakened when -- as it is often the case – rescue operations force healthy banks to bear the losses of ailing institutions. Finally, loose monetary policy to shore up banking sector losses can be inflationary and, in African countries with an exchange rate commitment, it may trigger a speculative attack against the currency.

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