4 Developing Sound Banking Systems and Practices in Africa

Laura Wallace
Published Date:
January 1999
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Piero Ugolini

It is a singular privilege for me to participate in this seminar on challenges of globalization in Africa. The theme of the conference is both topical and timely, considering the recent progress made and the challenges faced by the sub-Saharan African countries in the area of financial sector reform. Banking soundness and the need to contain moral hazard and promote market discipline are the issues of the day, particularly as a result of the Asian crisis. In reality, these are concepts that have existed for a long time in the financial world and often have been neglected until a financial crisis emerged. Franklin D. Roosevelt stated in 1933, in the aftermath of the Great Depression:

As to guaranteeing bank deposits, the minute the government starts to do that the government runs into probable loss. We do not wish the United States government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future.”

The existence of a sound banking system in African countries is a relatively new concept and challenge. Since independence, about 30 years ago, the financial sector in these countries has undergone domestic changes and evolution, sometimes not intended and not always favorable. It is only recently that the soundness of the financial sector has become relevant and important. As a result, some actions have been taken by these countries to develop financial sectors, and in recent years, some progress has been made. But much remains to be done. The need for these countries to do more is made even more urgent and essential, given the increasing globalization of the world economy. Globalization poses a real threat to Africa’s further marginalization, but it offers at the same time a welcome opportunity to speed up economic growth and development, and to raise living standards, if efforts are made and maintained towards achieving lasting macroeconomic stability. The bottom line is that Africa will have to accelerate structural reforms, particularly in the financial sector, if it hopes to attract large volumes of capital investment.

So where do financial sector reforms in Africa stand and how can the IMF help? My department, the Monetary and Exchange Affairs Department, recently conducted a study on this very topic. We took a sample of about 35 countries, primarily focusing on central bank operations and the central bank framework, just touching lightly on the banking sector and nonfinancial institutions.

I would like to share with you some of the results, describing briefly how the financial sector has evolved, the key existing problems, and suggested reforms and their sequencing.

Overview of Financial Sectors

After independence, owing to prevailing political ideologies, expansionary economic policies, and different types of influences—including internal and external shocks, such as the sharp increases in petroleum prices and the deterioration in African countries’ terms of trade—real growth was severely impaired and inflation extremely high. During the 1970s and 1980s, the growth rate of GDP at constant prices declined and was about one-half the average rate in developing countries as a whole. Inflation was, on average, 25 percent a year.

During this period, Africa placed a great emphasis on developing and protecting the real sector. Government intervention and protectionism became the main policies to develop the domestic economy. This was done largely through directing preferential credit to the real sector, especially agriculture and public enterprises. In other words, the financial sector was accorded only an ancillary role in the development process, that of channeling credit to the government and preferential sectors, without assessing the risk and efficiency of such credits.

The net effects of these developments on the financial systems were that financial institutions were weakened, financial instruments became irrelevant, the credibility of financial policy was eroded, and parallel markets effectively marginalized the formal financial sector. Under these circumstances, the development of the financial sector was severely constrained for a number of reasons:

  • The central bank was seen as part and parcel of the government machinery, designed mainly to provide credit to the government. And since there was no monetary policy initiative to be taken, the issue of central bank autonomy did not even arise.
  • Whatever financial market there was, existed simply for the sale and purchase of government treasury bills at predetermined interest rates, although the bulk of the loans to the government were granted through ways and means advances (direct credits at zero percent interest).
  • Because the regime was characterized by direct credit to government and parastatals, which had neither the ability nor the incentives to repay debts, the portfolios of the commercial banks were severely burdened with nonperforming loans. The commercial banks, in turn, did not provide for nonperforming loans, as they were loss-making and poorly capitalized. Capitalization of state-owned banks, of course, had direct budgetary implications and hence was ignored. Virtually all development banks became insolvent and illiquid. Competition within the banking system was limited and in some cases nonexistent, because of controls over most, if not all, prices, including interest rates and exchange rates.

By the late 1980s and early 1990s, faced with a deteriorating world economic picture, African countries embarked upon a policy of adjusting their economies and dismantling controls and restrictions that had become institutionalized. This adjustment was generally implemented within the context of IMF- and World Bank-supported stabilization and structural adjustment programs (the structural adjustment facility, or SAF, starting in 1986, and the ESAF, starting in 1987). In fact, by end-1996, 21 out of 48 African countries were implementing these programs.

The reform measures included fiscal and financial measures to reduce inflation, open up the trade and payments system, and liberalize prices, production, and marketing of most goods and services. The measures also included structural measures to avert the need for repeated depreciations of the domestic currency and restore confidence in domestic markets. Overall, the objective was to achieve noninflationary, private sector-led growth within a market-based economic system.

Importantly, as part of the overall adjustment program, a large number of African countries also undertook financial sector reforms. These reforms included liberalizing interest rates and eliminating administrative allocation of credits, granting more autonomy to central banks in the conduct of monetary policy, and instituting a transition from direct to indirect monetary policy instruments. These countries also began paying more attention to restructuring commercial banks to restore solvency, developing financial markets—mainly primary markets for government securities—and improving financial infrastructures, including bank supervision, auditing, and accounting practices.

African countries, as a whole, have made significant strides in adjusting their economies, with the result that growth is beginning to pick up and per capita incomes are once again on the rise. Even though the adjustment period has been relatively short, most macroeconomic indicators show significant results. Indeed, real GDP growth has, on average, doubled from its prereform level in the mid-1980s of 1.5 percent a year.

Existing Problems

Despite this recent progress, considerable work still lies ahead and financial sector reform remains at an embryonic stage. Our study highlights the following:

  • Most central banks have only limited autonomy to perform appropriate monetary and supervisory functions. Government interference in credit extension, bank licensing, and supervision encroaches on fulfilling the main mandates of the central bank—that is, maintaining price stability and ensuring the soundness of the financial system.
  • The financial sector suffers from a lack of competition created by the monopolistic position of large government-owned banks; the lack of a level playing field discourages the entry of private and foreign banks.
  • The large share of nonperforming loans in the balance sheet of the largely government-owned commercial banks impedes the development of interbank markets, since sound banks do not want to deal with unsound banks.
  • The absence of a complete array of monetary instruments (portfolio securities) and a dearth of expertise constrain central banks’ ability to deal with the excess liquidity created by governments’ expansionary policies.
  • The large share of nonperforming loans, the lack of competition in the financial sector, and high administrative costs, as well as high reserve requirements, are at the root of the large spread between deposit and lending rates.
  • The crowding-out effect of government borrowing pushes the interest rate structure upwards and discourages borrowing for long-term investment. What is puzzling is that commercial banks often seem to be content to hold excess reserves, earning no interest, yet demand from potential borrowers in the private sector goes unmet—forcing these borrowers into the informal financial sector.
  • The regulatory framework for supervision is moving toward full compliance with the Basel core principles, but its implementation is not always very effective. The authorities are tardy in dealing with insolvent financial institutions, owing to political and social pressures. Loan recovery is also hampered by bottlenecks in the judicial system.
  • The economic and political uncertainties encourage investors to opt for short-term speculative investments, at the expense of building up savings and expanding long-term credit.
  • The inefficiency of the payments system—which was not important under a highly controlled economy but takes on immense importance under a market-based system—hurts financial sector development, keeps payments system risks high, and hampers the transmission mechanism of monetary policy. In Zambia, for example, the float period for clearing checks was two weeks for Lusaka, and three or four weeks for the copper belt region. But now, with technical assistance from the IMF and the cooperation of commercial banks, it is down to only two or three days for Lusaka and about one week for the copper belt.
  • The constraint imposed by the dearth of well-trained and qualified nationals limits the formulation and implementation of sound financial policies. This problem has persisted because of a lack of specialized institutions catering to financial sector needs.

Sequencing of Reforms

So what can we learn from other countries’ experiences with financial sector reform and how should reforms be sequenced? This is undoubtedly one of the trickiest questions. We believe that a key lesson is that policymakers should begin with getting the fiscal deficit under control and establishing macroeconomic stability. Clearly, reforms cannot be carried out against an unstable macroeconomic background. The government should implement policies aimed at increasing efficiency and competition in all areas of the economy, particularly the financial sector. Indeed, the vital role of banking soundness, from a macroeconomic perspective, is a point that the IMF has been repeatedly trying to drive home.

The experience of industrial, developing, and transition economies indicates that an unsound, uncompetitive banking system, and inadequate institutional and regulatory framework weaken efficient credit allocation, distort the structure of interest rates, disrupt monetary policy signals, and impose significant fiscal costs. In Uganda, for example, broad money used to account for about 25 percent of GDP, but after a high rate of inflation took hold, broad money dropped to around 9 percent of GDP, where it remains in 1998.

Insofar as macroeconomic stability is vital for financial sector development, a sound and well-functioning financial sector is essential for guaranteeing macroeconomic stability. This dual relationship is mutually reinforcing and fully justifies the need for governments to tackle both issues at the same time. How should countries proceed? I would like to suggest bold measures in eight key areas.

Legal and Regulatory Framework

An efficient and strong financial system has to be founded on an appropriate legal and regulatory framework. The latter is indispensable for a sound financial system within which the authorities must have autonomy and be accountable for the system’s operations. In order to attain a suitable level of autonomy for central banks and provide accountability, governments should do the following:

  • Promulgate central bank legislation containing, at a minimum, provisions that give explicit priority to price stability as the objective of monetary policy.
  • Give authority to a single institution, preferably the central bank at the initial stage, for the overall supervision of the financial system.
  • Consolidate the licensing and revocation of licenses in a single unit, again, at least initially in the central bank, thereby making one single unit fully accountable for the licensing and performance of financial institutions. In Africa, responsibility for licensing is often split between the central bank and the finance ministry. As a result, the finance ministry sometimes grants licenses, under tremendous political pressure, to which the central bank objects.
  • Require an institutionalized, transparent mechanism for resolving divergences between fiscal and monetary policy.
  • Ensure that governors of central banks and members of boards of directors do not come under undue political influence, possibly through careful legislation. In many African and some Asian countries, there is no official appointment for the central bank governor, meaning that the governor can be removed by the prime minister on a whim. At the other extreme is Italy, where the governor is appointed for life.
  • Place explicit and reasonable limits on the amount of credit that can be granted by the central bank to the government and ensure that these credits are collateralized by income-yielding assets, bearing market-determined rates. In Poland, for example, the government moved quickly in 1989 to amend the central banking law to limit credit to the government, paving the way for tremendous progress in the financial sector.
  • Do not impose on the central bank the obligation to undertake quasi-fiscal activities, and ensure the financial viability of the central bank.
  • Improve the judicial system to accelerate recovery of bad loans.

Well-conceived legislation, however, only represents a necessary condition for central bank autonomy. A sufficient condition would be the commitment by governments to ensure compliance with the provisions of the legislation. In this regard, it could be useful to set up independent, specialized courts that deal only with matters relating to the financial sector. This is likely to speed up the settlement of financial contractual cases and, above all, send a clear signal regarding the direction and intention of the authorities.

The recent Asian crisis has underscored the importance of separating the monetary authorities from the “political establishment,” and providing autonomy and authority for prompt actions.


As economic stabilization has progressed in Africa and inflation rates have come down, there is a need for commercial banks to strengthen balance sheets, increase provisioning for nonperforming loans, and strengthen credit and market risk analysis. Thus, firm, timely, and effective supervision is essential to ensuring that these imperatives are followed. This means adopting international, best-practice accounting standards, complying with the basic supervisory standards relating to prudential regulations—as indicated by the Basel Committee’s Core Principles for Banking Supervision—and putting in place examination procedures, including on-site inspections and off-site surveillance, that are capable of identifying weaknesses.

The recent Asian crisis clearly shows how the lax prudential supervision of financial institutions can undercut economic progress. In most of the Asian crisis countries, the minimum capital adequacy ratio of 8 percent was met, at least on paper, by most banks. But this was only because most of the insolvent banks adopted unconventional accounting practices and misclassified assets.

In dealing with the Asian crisis, the IMF has emphasized the need for a comprehensive financial restructuring strategy to restore confidence and reestablish the soundness of the financial system. Broadly speaking, the IMF-supported programs have included efforts to:

  • identify and promptly close insolvent institutions;
  • recapitalize and restructure weak but financially viable institutions;
  • strengthen the operational viability of financial institutions through introducing internationally accepted best practices in the areas of asset valuation, capital adequacy, accounting, and public disclosure;
  • improve the regulatory environment and compliance; and
  • enhance competition and efficiency, including through measures such as the eventual privatization of state-owned financial institutions and increased foreign participation.

Payments System

Besides South Africa, which has a fairly well-established payments system—and the South African Development Community and CFA franc countries, which have begun to address payments system policies and procedures—the modernization of payments systems in the rest of Africa has been neglected. Indeed, these systems are in dire need of restructuring to avoid systemic risks and failures. Apart from the bottlenecks that are created in effecting settlements, the weak payments systems impose serious constraints on developing other aspects of the financial sector, because of their interface with monetary operations and instruments and with the core financial markets. Additionally, given the rapidly increasing use of banks in African countries, juxtaposed against the still predominant use of checks as the main instrument of payments, urgent steps are called for to modernize the payments systems.

The experience of other countries, such as Poland and some others in Eastern Europe, that moved from direct to indirect instruments of monetary management, shows that large and erratic float movements hinder the transmission mechanism of monetary policy implementation. Such floats create a problem for forecasting short-term (daily and weekly) liquidity and force banks to hold large excess reserves in order to avoid settlement penalties. This impairs the profitability for banks, which then pass on the cost to consumers by widening the spread between deposit and lending rates.

Accounting and Internal Audit

In this area, while we can identify a few good examples of central bank accounting and internal audit reforms, progress for the vast majority of countries has been slow. Why the slow pace? The main reason, especially for former centrally planned countries, which are faced with the task of reinventing accounting systems, is a problem of perception. Accounting is still considered a bookkeeping and recording function that does not rank as a high priority in most countries. Regrettably, policymakers fail to appreciate the close links between an increasing reliance on market forces and access to timely and reliable information for sound decision making. Thus, efforts must now focus on education, if Africa is to modernize its accounting systems and establish an internal audit system capable of examining, evaluating, and monitoring the adequacy and effectiveness of accounting and internal procedures.

Sound Banking System

Good economic policy needs a sound banking system. Unsound banks threaten the real sector, weaken monetary policy, impose fiscal costs, and produce exchange rate instability. Given the financial sector’s vulnerability to wrong policies, it is essential that authorities create a level playing field where sound competition can guarantee efficiency and better services to the population.

In most African countries, government-owned (and even partly owned) banks dominate the financial sector. Their inefficiency is reflected primarily in large spreads between deposit and lending rates and weak financial intermediation. Injecting competition in the financial sector by splitting and privatizing government-owned banks is critical for developing the interbank market and secondary trading activities. In addition, the portfolio has to be diversified. This means the portfolio of risks, credit, market, on- and off-balance sheet has to be well spread. The bank has to be profitable. After all, a loss-making bank will rapidly degenerate unless drastic steps are quickly taken. The bank has to be liquid and well capitalized and should eschew undue risks that arise from acquiring low-quality assets and taking inappropriate domestic and external positions. Apart from the high levels of integrity expected of management, a sound bank has to have in place prudent credit approval procedures, risk limitations, and appropriate internal credit control.

To preserve and ensure soundness—and here I would like to recall the old adage that a sound bank is only as sound as its management—policymakers must provide discipline and incentives for good management by emphasizing the transparency of banking activities.

  • A sound banking framework should produce timely and reliable information for use by management, supervisors, and market participants.
  • There should be public disclosure by banks to the market, and rating agencies should be encouraged in order to facilitate private sector credit activities and develop capital markets.
  • Banks should report regularly to supervisors all relevant information, including market-sensitive developments, drawing on international, best-practice accounting standards.

Limiting Public Sector Distortions

How about when banks are in crisis, raising dilemmas for the supervisory authorities?1

Lender-of-Last-Resort Facilities. The role of lender-of-last-resort by the central bank has often been wrongly used to support insolvent banks and undermines the discipline and profitability of the banking system. The true role of the central bank, instead, should be to provide temporary assistance to illiquid but solvent institutions. To do this effectively, the central bank must be able to distinguish between illiquid and insolvent banks, and this means having access to all the relevant information.

Exit Policy. A sound banking sector needs a credible exit policy to deal with insolvent banks. Here, too, timely and reliable information should be available to supervisors. Moreover, an appropriate legal framework must be in place to ensure that if banks are closed, it is done strictly on financial grounds—in other words, free from any political interference.

Deposit Insurance. Deposit insurance schemes are prone to problems of moral hazard. They should be designed and implemented as insurance in the event of a bank failure—not as a panacea or substitute for strong supervision. In Africa, encouragingly, we are beginning to see some deposit insurance schemes implemented for the purpose of protecting those with small savings.

Capacity Building

The IMF study clearly identifies the need to develop human capital, so as to expand the professional class of qualified nationals able to efficiently operate the monetary and exchange rate systems. Indeed, African countries, as a whole, still lack sufficient numbers of financial regulators, supervisors, and managers who could maintain high professional standards.

What can be done? The IMF—in close coordination with the World Bank, other bilateral and multilateral institutions, and possibly regional African organizations—could set up well-focused technical assistance programs. These should effect the required transfer of knowledge to develop human capital and improve existing structures.


For African countries to undertake the necessary reforms that have been outlined above, two vital and complementary courses of action need to be speedily embarked upon. First and foremost, African governments must make a strong commitment to reform and demonstrate strong leadership if they hope to create an atmosphere of economic security and good governance within which reforms can take place.

Second, Africa needs to develop local capacity for the efficient design and implementation of monetary and exchange rate policies on a routine basis. Of course, there are technical, institutional, and human resource constraints facing most African countries. This is where the international community—the IMF, the World Bank, and other bilateral and multilateral institutions—can help, by supporting reform efforts through the provision of technical assistance and training. The progress made so far augurs well for the future. It is vital to build upon it now. Indeed, the IMF is considering how best to intensify its technical assistance program in Africa, chiefly in the areas of monetary operations, bank supervision, payments system development, and human capital development.

I would like to conclude by reiterating that banking soundness is essential for economic growth and we should learn from past mistakes. Unfortunately, some of the lessons of the past have not been learned well. In Florence, in the fourteenth century, two banks, the Bardi and the Peruzzi, were the giants of the industry. But they eventually collapsed largely because they failed to collect loans from existing monarchies, notably Edward III, King of England, and Robert the Angevin, King of Naples. The Medici family, which was a competitor of the two banks, learned from this failure and adopted a more diversified credit policy by avoiding credit concentration, spreading risk, increasing lending to private traders, and reducing credit to the royal families. The Medici Bank became one of the strongest in the world, dominating the financial world for over a century, until political forces, mostly from Rome, sought to destroy its business and accelerate its fall. In the end, the Medici family was expelled from Florence during the French invasion of 1494.

Thus, it is proper, a little more than 500 years later, to pose the question: Is political interference still contributing to banking crises?


For details, see David Folks-Landau and Carl-Johan Lindgren, Toward a Framework for Financial Stability, World Economic and Financial Surveys (Washington: International Monetary Fund, 1998).

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