FROM THE OFFICE OF PUBLIC AFFAIRS

Importance of Financial Sector Development

Financial sector development is one of the keys to economic growth as it facilitates savings and investment. If Sub-Saharan Africa is to provide its growing population with sufficient food, productive jobs, and rising incomes, its economies must grow by at least 4-5% a year, if not more. To do this, the region must improve productivity, increase investment, and dramatically raise levels of domestic savings. The level of domestic savings in sub-Saharan Africa remains below that of all other developing regions, representing only about 12% of aggregate GDP. Savings rates in Asia, meanwhile, are as high as 30%, and even in South Asia the savings rate is 17%. 

To increase public savings, governments must focus on reducing expenditures. In addition, much can be done to increase revenues, without raising marginal tax rates, by eliminating exemptions and broadening the tax base. To encourage private savings, governments must reform property ownership laws and more broadly promote private sector development, improve the investment climate, build infrastructure, and increase access to credit. Strengthening financial sectors is critical to supporting such reforms. In addition, reforming weak banking sectors can have a direct impact on savings as weak banks tend to have higher loan-to-deposit spreads and thereby discourage savings and investment. 

A stronger financial sector is also critical to improving income levels. Low-income families, small-to-medium size enterprises, and rural entrepreneurs in developing countries have difficulty obtaining financial services. Banking sector penetration in a typical sub-Saharan African country is around 1% of GDP, far below a more advanced economy like Brazil, where penetration is approaching 25%, or industrialized countries where it is near 85%. Women’s World Banking estimates that fewer than 2 percent of low-income entrepreneurs worldwide have access to financial services.

In Africa’s agriculture sector, women receive less than 10% of the credit to small farmers and less than l% of the total credit to agriculture. 

Developing the financial sector is also necessary for preventing the financing of terrorism and combating financial crimes. In many African countries, banks are the primary financial intermediary. They are the key repository for the public’s savings and the main source of credit to firms. Fragile banking systems not only misallocate resources, but also leave themselves vulnerable to terrorists, money-launderers, and others who would abuse the financial system.  

Challenges for Reform

While several Sub-Saharan African countries have already made substantial progress in reforming and modernizing their financial sectors, there is still much work to be done: 

• Banking systems often still operate with a substantial degree of government ownership or control. During the 1980s, when many African countries faced external shocks, the primary cause of financial distress of banks was political, in the form of pressure not to recover debts, or to lend to weak borrowers including parastatals, politically connected private sector borrowers, and the government itself. 

• Bank supervision remains weak, enforcement tools inadequate, and management standards low. Most African financial sectors need reform in the areas of prudential regulations, banking supervision, bankruptcy laws, and contract enforcement law. Compliance with international codes and standards is also an area in need of reform. 

• The depth and breadth of Sub-Saharan Africa’s financial markets are inadequate.  The banking industry is highly concentrated (in a study of 11 Sub-Saharan African countries, 60% of banking sector assets were concentrated in, at most, 4 banks); loan portfolios are not diversified, reflecting national economies; capital markets are shallow; and insurance and pension systems are not well developed. 

Without reforms in these areas, financial systems will continue to experience high levels of non-performing loans, interest rates that do not adequately reflect the level of risk, and crowding out of the private sector. 

Value of Openness and Competition within the Financial Sector

We at Treasury believe that openness to foreign direct investment in the financial sector coupled with improved financial supervision and regulation is a clear path to economic growth and stability. Foreign financial institutions can introduce strong business practices, technology, products, and risk management systems. And, of course, foreign financial institutions can bring their own financial resources to bear as well. 

Financial sector openness offers two fundamental benefits to those who undertake it.  First, a more open and well-regulated financial sector is more efficient and more robust.  It acts as an “engine of growth” for the entire economy.

 The financial sector has an economy-wide effect. All other sectors rely on financial intermediation for growth.  Second, perhaps more than in any other economic sector, a stronger, deeper financial sector can protect an economy from external as well domestic shocks. Therefore, financial sector openness can promote stability. 

How does financial sector openness lead to growth? Well, we know that the world’s best financial institutions are better able to identify productive investment opportunities and then more quickly move domestic savings into them—in short, the better they perform their capital intermediation function, the faster an economy can grow. 

Another benefit of a competitive, open system is that it forces all financial firms operating in an economy to offer the highest returns to savers and the lowest cost of capital to investors. Under the right conditions, competition from international firms leads to narrower spreads, and stimulates both savings and investment. 

As financial institutions aggregate capital, they must move it into the business and industry sectors where they can earn the best risk-adjusted returns for their savers. That means investing in the businesses that can make the best use of their capital—in other words, those that offer the highest productivity. And rising productivity—output per worker—is at the root of raising living standards. 

There is a particular need for more attention in the areas of finance for small- and medium-sized enterprises (SMEs) and the prevention of terrorist financing and financial crimes. 

Improving SME Access to Finance 

A necessary ingredient for value creation is a means of providing capital to those who seek to make new ideas into reality. That is, to entrepreneurs. It doesn’t matter if the new idea is building a satellite-linked data processing center in Accra, or putting a dairy cow in an empty barn in Kosovo. 

As these entrepreneurs succeed, they diversify the local economy. Often businesses such as restaurants, general stores and clothing-makers are the first non-agricultural employers in their communities. They are the seeds for local economic independence, specialization, comparative advantage in trade, and long-term growth. They create jobs that keep young people at home, where they would otherwise move to over-crowded cities—or other countries—in search of work. They launch a virtuous cycle of growth and employment. 

In most Sub-Saharan countries, SMEs and microenterprises have limited access to financial services, yet they make up the vast majority of businesses in Sub-Saharan Africa. In recent years, multilateral development banks, governments, and NGOs have developed programs to finance microenterprises. SMEs would best be served by the local banking sector which could provide working capital loans in local currency, but this sector is underdeveloped in many countries. 

The US Treasury and the International Finance Corporation (IFC), the arm of the World Bank group that invests in private companies, are working to establish an IFC-managed facility that would develop local private financial institutions in Africa to serve the financing needs of SMEs. While many multilateral and bilateral donors have in recent years increased their financing for African microenterprise development, there are few programs that target SMEs. This idea has a successful analogue in the US-supported SME finance facility of the European Bank for Reconstruction and Development (EBRD). The US hopes that IDA would fund the development of this SME financing facility for Africa. 

Combating Financial Crimes and Terrorist Financing

Well-regulated financial sectors that can institute and implement effective asset-freezes, know-your-customer requirements, and policies that ensure transparency are the first line of defense against terrorists, money-launderers, and other financial criminals. To combat the financing of terrorism, governments must first ensure that they have the appropriate tools to freeze and seize any terrorist-related assets, establish financial intelligence units to track flows of funds and share information, implement oversight of alternative remittance systems such as foreign exchange bureaus, and provide adequate protections against the abuse of charitable institutions by the financiers of terror. 

The U.S. Treasury Department and the African Development Bank have been working on organizing a regional banking conference in Africa to discuss necessary reforms. The two-day conference would cover developments in the international community to thwart the flow of funds to terrorists and combat money laundering, and would then delve into how to build on these developments to strengthen a country’s financial system and track terrorist assets. 

The Example of Ghana

Ghana took a very systematic approach to reforming its financial sector in the early 90s.  In the first phase of those reforms, the government placed ceilings on net bank credit to the government to avoid crowding out the private sector. While administrative controls on interest rates remained in place, they were gradually relaxed. The second phase of reform focused on liberalizing controls on interest rates and bank credit. In the third phase, there was a gradual shift from a direct system of monetary controls to an indirect system that utilized market-based policy instruments. 

As part of the process, the Bank of Ghana rationalized the minimum reserve requirements for banks, introduced new financial instruments, and absorbed excess liquidity from open market operations. These policies were complemented by improving the soundness of the banking system by improving the regulatory framework, strengthening bank supervision, and improving the efficiency and profitability of banks, including the replacement of their non-performing assets. In the final stage of this process, Ghana has embarked on the privatization of the major publicly owned banks. 

Conclusion

Financial sector development is critical to stronger economic growth, improved productivity, increased investment rates and better savings rates. A competitive and open financial sector can play a critical role in this process. Also, bilateral and multilateral development partners must assist African countries to make tangible progress toward economic and financial sector reform. The IFC SME facility will facilitate that process by building and strengthening financial institutions which can serve the SME sector, which typically is the primary engine of job creation in many countries around the world. In addition, the Treasury Department provides technical assistance in the areas of banking supervision.