N° 100 - July 2009

Financial Sector Policy Reforms in thePost-Financial Crisis Era: Africa Focus

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Correct citation : Lemma W. Senbet (2009), Financial Sector Policy Reforms in the Post-Financial Crisis Era:Africa Focus, Working Papers Series N° 100, African Development Bank, Tunis, Tunisia. 48 pp.

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Working Paper No. 100July 2009

Financial Sector Policy Reforms in the Post-Financial Crisis Era: Africa Focus1

(1)This Working Paper is published from a consultancy report prepared by Lemma W. Senbet, presented at aworkshop on the Global Financial Crisis hosted by the African Development Bank on 10 April 2009 in Tunis,Tunisia.

This policy-oriented paper presents and rationa-lizes short-term policy responses to current cri-sis and long-term regulatory and financialreforms for post-crisis Africa. The analysis isconducted in the following sequence. It pre-sents reversals of gains in economic and finan-cial sector performance that are bound to occuras a result of the damage stemming from theglobal crisis. For the short term, it discusses therole of African global partners in coping with theimpact of the crisis, and Africa’s positioning in

the moving-forward of global financial reforms.It then keys on Africa’s own responsibilities andcatalogues a series of long-term reforms to miti-gate the severity and frequency of future crisesin Africa and/or the impact of crises comingfrom outside Africa. It concludes with a call forcontinuing engagement with market-orientedreforms and globalization, and resistance to thetemptation for policy reversals, while adoptingthe long-term policy reforms catalogued in thepaper.

Abstract

Lemma W. Senbet, University of Maryland

Keywords: Financial crisis, reforms, globalisation JEL classification: G2, G20, G28

1. Introduction2. Essential Factors to be Considered in the Propagation of Crisis

2.1. Bubble and Bust2.2. Critical Factors

3. Africa On the Move, But Damage from Global Crisis3.1. Real sector payoffs to reforms, but now deceleration3.2. Financial sector payoffs, but now reversing

4. Africa and Global Responsibility4.1. Short-term mitigation of collateral damage to Africa4.2. New global financial order: Africa has a stake in what the rest of the world does

5. Africa and Its own Responsibilies: Getting House in Order5.1. Building infrastructure for crisis resolution5.2. Should banks be renationalized in Africa?5.3. Reforming banking regulation5.4. Reforming stock market regulation: A brief5.5. Governance: overhauling bank governance and corporate governance5.6. Fostering market depth and functionality5.7. Building capacity for oversight of risk and risk management5.8. Managing financial globalization5.9. Policy reversals? Continuation of a market-based reform path

6. Concluding NoteReferencesFiguresFigure 1: Complex and Opaque SecuritizationFigure 2: Market Meltdown Around the GlobeFigure 3: Volatility Spikes for Selected African CountriesFigure 4: Bank Investments and Deposit InsuranceFigure 5: Incentive Features of Bank Management Compensation StructureFigure 6: Regional Ratings: Sub-Saharan Africa versus OthersTablesTable 1: Africa: Selected Macroeconomic Indicators, 2003-2007Table 2: Positioning of Sub-Saharan Africa in World Financial DevelopmentTable 3: Financial Development and Selected Determinants Africa versus the Rest of the

World, 1995-2007Table 4: African stock markets performance in crisisTable 5: Country Ratings

1334669

161620212225273233373840454647

51315293443

710

111444

Contents

I. Introduction

Africa is being collaterally damaged bythe financial crisis that began in the USand spread all over the world. While theUSA is the epicenter, the financial crisishas resulted in a global economic crisis.Even the countries not integrated into theglobal financial economy (e.g., Ethiopia)are hurt. This current global crisis isunprecedented since the GreatDepression. Resources to the tune of tril-lions of US dollars have been expendedby the more advanced economies in theform of fiscal stimulus to jump start theireconomies, and in the form of bailout pac-kages to rescue failing financial institu-tions and to stabilize the financial system.

While the advanced countries have com-mitted exorbitant sums of money, develo-ping countries, particularly Sub-SaharanAfrica, lack commensurate resources forfiscal stimulus and bailout packages. Yet,without their own fault and despite themany years of extensive reforms, Africaand the other low-income countries arebeing devastated by the adverse conse-quences of the global financial crisiswhich has been transmitted both throughthe financial and real sectors. Commodityprices, as well as exports, have plungeddue to the slump in global demand.Foreign direct investments and portfolioflows are drying up. Moreover, the globalcrisis of confidence is leading to a rise in

costs of borrowing in the credit markets,and, more disturbingly, emerging andpre-emerging economies are being ratio-ned out of the credit markets altogether.

The African situation is particularly worri-some, since in addition to the decline inthe traditional flows of trade and invest-ment, the global crisis is having a devas-tating effect on remittances. Further,given that the donor countries are nowcommitting unprecedented quantities ofresources to cope with their own crisis,the aid flows are likely to shrink. There isvery little that is counter-cyclical in thispicture to mitigate the devastating impactof the global Tsunami on Africa and otherlow-income countries.

No one is spared in this environment.Advanced economies, emerging econo-mies, pre-emerging and low income coun-tries are all hit badly. Eastern and CentralEuropean countries, such as Hungary, theCzech Republic, and Poland, are expe-riencing severe damage both in the realand financial sectors. Exports from thesecountries to Western Europe have dimini-shed. They are also caught up in themisfortunes of major European bankswhich have experienced huge lossesresulting from their exposures to the USmortgage-backed securities. East Asiancountries are also hurt from the globalslump in demand and plunging globaltrade. So are Latin American countries.

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The impact of the global crisis on the pri-vate capital flows to emerging markets isparticularly stunning. These flows drop-ped almost 50%, from $928 billion in 2007to $466 billion in 2008(2). It is now beingprojected that private flows will dwindle to$165 billion this year. What is also inter-esting is that foreign holdings of US T-bills rose by $456 billion in 2008 – almostto the tune of the decline in private capitalflows to emerging economies. Ironicallythe US Treasury securities have actuallybenefitted from the USA being the epicen-ter of the global financial crisis, a pointthat I wish to return to later.

How does all this aggregate globally?The global trade is falling rapidly, andcommodity prices are plunging. The bot-tom line projections for the performanceof the global economy are very unfavo-rable. Both the IMF and the World Bankestimates, more or less, agree on this.According to the IMF, we are headed forthe worst economic performance of gene-rations this year, with the global growthexpected to move into a negative territory.This is consistent with the prediction ofthe newly released World Bank report thatthe global economy would shrink in2009(3). This is the first time experience inmore than half a century.

The global crisis has revealed seriousoversight gaps in systemically critical ins-titutions, such as AIG in the USA, whichcan engender global interconnectednessby taking advantage of the boom in anundisciplined and unregulated environ-ment. With the system of distorted incen-tives for exorbitant rewards in the boomperiod, excessively high risks, yet non-transparent (e.g., credit default swaps),were undertaken. Bank-like institutions,which are outside the banking regulatoryscheme, were allowed to grow to a pointwhere their failure would bring down otherinstitutions, with damage to the entireglobe. However, there are no global sys-tems in place for the accountability of thecountries that source crises of epic pro-portions and impose enormous collateraldamage on other countries, particularlyfragile and low-income countries.

No doubt, the world is facing “GreatRecession” that can devolve into the“Great Depression” if bold actions are nottaken. Given that this is a global crisis,these actions must be globally coordina-ted. Although the burning issue now iseconomic recovery, it is also vital that weuse this opportunity to carry out long-termreforms for the mitigation of such crises in

2

(2)Report of the Institute of International Finance (2009).(3)IMF report “Impact of Global Financial Crisis on Sub-Saharan Africa” (2009), World Bank “Global Economic

Prospects” (2009)

the future. The purpose of this paper is topresent and rationalize some long-termregulatory and financial reforms with afocus on Africa. The crisis makes it clearthat what goes on in other countries mat-ters, and the reform package implemen-ted abroad are relevant to Africa.Concerning the long- term reforms, atten-tion should be paid to both the home-grown reforms and those from abroad.The voice of Africa and low-income coun-tries should be heard while their participa-tion should be effective in the reform ofthe global financial system and the regu-latory structure.

Following the introduction, section II ofthis paper provides a brief on the rootcauses of the crisis. Understanding thecauses help us understand the long-termreforms toward the prevention of crisesand mitigation of the potential associatedcosts. Section III overviews the recenteconomic and financial sector reformsthat have contributed to real economicgains in Africa. It then analyses the rever-sals in economic and financial sector per-formance that are bound to occur as aresult of the damage stemming from theglobal crisis. Section IV discusses the roleof African global partners in coping withthe impact of the crisis and Africa’s posi-tioning in global financial reforms moving-forward. Section V keys on Africa’s ownresponsibilities and catalogues a series oflong-term reforms to mitigate the severity

and frequency of future crises in Africaand/or the impact of crises originatingfrom outside Africa. Section VI is theconcluding note.

2. Essential Factorsto be Considered in thePropagation of Crisis

Many have written about the root causesof the financial crisis that began in theUSA and spread around the globe andgot transformed into a generalized econo-mic crisis. It is important to briefly identifythe critical factors that are relevant to thestudy of the impact of crisis on Africa.

2.1. Bubble and Bust

The last decade has witnessed two land-mark events. The burst of the informationtechnology boom and the associatedmassive corporate scandals triggered acollapse of highly reputed and large com-panies such as Enron, WorldCom, Tyco,Adelphia, Global Crossing, etc. This resul-ted in massive destruction of shareholderwealth and damage to other stakeholders,including employees who lost retirementsavings.

The second landmark event is the burst ofthe housing bubble and the subprime cri-sis, and it has lead to a shutdown of thecredit market. This too resulted in massi-

3

ve destruction of equity and real estatewealth. However, the burst of the techno-logy bubble and the corporate crisis waslargely limited to a single industry sectorand a single country (USA), whereas thecurrent crisis, which is rooted in the hou-sing bubble, has spread around the world.Moreover, the damage has been pheno-menal and it is unlike anything we haveseen over generations. The crisis eruptedwith the dramatic failures of the venerablefinancial institutions, such as LehmanBrothers, Merrill Lynch, American Interna-tional Group (AIG), Fannie Mae, etc. andspread around the globe with the collate-ral damage being imposed on low-incomecountries, which are not even that integra-ted into the global financial economy.

However, there is a commonality charac-terizing the two landmark episodes of thedecade. At the center of these episodesare lack of accountability, poor disclosure,distorted incentives, and severe regulato-ry gaps. This commonality has a universalear to it, and hence very relevant toAfrica. This is a point I wish return towhen I discuss incentive-based reformsfor the banking and overall financial sec-tor in Africa (see Section 4).

2.2. Critical Factors

For sure, housing boom and credit boomare at the center of the crisis. A housing

bubble created overinvesting in homes,along with overbuilding. Thus, ex ante,banks and other financial institutions,including government-sponsored agencies(GSEs) and those on Wall Street, bet bigon home prices – one that didn’t work outex-post. However, this is not the full pictu-re of what propagated the crisis, andother factors also played a critical role.

First, banks and other financial institutionswere excessively levered. Excessiveleverage creates incentives for excessiverisk-taking by the owners of these institu-tions. The existence of explicit or implicitinsurance can add to this “moral hazard”.Banks have explicit deposit insurance.However, other institutions (e.g., WallStreet firms) deemed too big to fail tohave implicit guarantees of a bailout.These features increase incentives totake excessively risky assets relative towhat is socially optimal. Weak corporategovernance and ill-designed executivecompensation contracts can further leadto distorted incentives, allowing execu-tives to be amply rewarded on the upsidebut escaping the downside.

Second, this was an era of grade inflationby rating agencies. Money funds wererequired, and others chose (e.g., insuran-ce companies) to hold only securities withhigh ratings (e.g., “AAA.”). As it turnedout, the “AAA” seal didn’t have normal

4

relation to defaults for mortgage-backedsecurities. Inflated ratings led debt inves-tors to buy securities at inflated prices.One might ask: why grade inflation? Oneexplanation has to do with the incentivestructure facing rating agencies. Theraters were being compensated by therated! The other explanation is that secu-ritization and financial innovation produ-

ced complex securities which were hardto rate (see below).

Third, complex securitization and tran-ching produced considerable opacity inthe system. The underlying risks associa-ted with these complex securities werenot transparent and very few recognizedthe gathering storm leading to the“Tsunami” (See Figure 1).

5

Figure 1: Complex and Opaque SecuritizationMORTGAGES

Relatively transparent andeasy to value but too small

to be individually liquid

MORTGAGE POOLSLarge enough to be liquid

and relatively easy to value

TRANCHESComplex, illiquid, andOpaque. Hard to value

HOUSEHOLDS

Houses

Tranches

MortgagesOwned

MortgagePools

TranchedSecurities

INVESTORS

SPECIAL PURPOSE VEHICLES INVESTORS

Debt

Equity

Under mortgage securitization, bankspackage individual mortgages into pools.The pools are then sold to special purpo-se vehicles (SPVs) that passively hold thepools. SPVs finance themselves throughcomplex securities involving multipletranches. The cash flow to each tranchedepends in complicated ways on the prin-cipal and interest repayments, prepay-ments, and defaults. With few disclosurerequirements, many types of tranche ins-truments, and a large number of SPVswith varied investors, tranches becameopaque and illiquid. When the crisis surfa-ced, nobody was sure what the securitieswere really worth.

There are other controversial factorscontributing to the global crisis, includingGreenspan’s easy-money policy. Thepost-dotcom period was a long period ofeasy money. The Federal Reserve Boarddid not pay much attention to the housingbubble and kept short-term interest ratestoo low. It is said that this was fueled byglobal macroeconomic imbalances intrade and capital flows, and huge savingsfrom export-led Asian economies werebeing channeled to the USA that helpedsustain low interest rates.

3. Africa On the Move, ButDamage from Global Crisis

Over the last two decades, most Africancountries have undergone extensive

financial sector and economic reforms,including large scale privatization pro-grams as well as the introduction of mea-sures to empower private initiative. Thepayoffs to these reforms have been sub-stantial and have accelerated over themore recent years. Now Africa’s gainsboth in the real and financial sectors arebeing derailed by the global crisis.

3.1. Real sector payoffs to reforms,but now deceleration

In the aggregate, Africa began rising inthe wake of the 21st century and had, infact, experienced what amounted to grow-th renaissance before it got caught up inthe global crisis. The GDP growth for thefive year period (2002-2007) prior to thecrisis averaged over 5.2 (see Table 1),outpacing population growth and henceexperiencing a significant increase inGDP per capita. Inflation was broughtunder control, and there was an improve-ment in fiscal discipline. Moreover, theregion experienced declining debt burdenand increasing capacity for debt service.This was accompanied by increasingforeign investment and remittance flows.

What is less noticed, though, but remar-kable is that African stock markets regis-tered impressive performance, relative toother emerging markets, even on a risk-adjusted basis. For sure, many chal-lenges remain, and there have been

6

home-grown reversals, such as inZimbabwe. Now Africa’s gains are threa-tened by external forces.

Of course, Africa is not just one country,but a continent of 53 countries. There is

large variation among these countries,and among regions, both in terms of poli-cy reforms, as well as economic perfor-mance. The 2007 GDP growth, for ins-tance, varied from 3.5% (West Africa) to8.0% in East Africa (see Table 1)(4) .

7

(4)According the latest AfDB report, Africa is now expected to grow at only 2.8% in 2009 – a reversal of 3% asa result of the global financial crisis.

Table 1: Africa: Selected Macroeconomic Indicators, 2003-2007

Sub-Regional GDP Growth and Per Capita Income: 2007

Selected Indicators 2003 2004 2005 2006 2007Real GDP Growth RatePer Capita Income ($)Domestic Investment Ratio (%)Fiscal Balance (% of GDP)Foreign Direct Investment flows ($B)Export Growth, volume (%)Terms of Trade (%)Trade Balance ($ billion)Net Total ODA flows ($B)Total External Debt (% of GDP)Debt Service (% of Exports)

4.978320.4-2.018.78.22.82.725.150.913.0

5.690921.4-0.118.07.86.14.027.545.111.2

5.71,04221.12.829.65.914.87.033.734.910.3

5.91,16121.84.235.52.88.67.841.326.29.9

5.71,29123.12.8N/A7.5-1.76.3N/A22.76.3

GDP Growth (%) Per Capita Income (¨$)

East Africa

North Africa

Southern Africa

West Africa

Central Africa

Africa

8.0

5.3

7.0

3.5

4.1

5.7

494

2,433

2,574

727

605

1,291

Source: African Development Bank statistics

There was sharp decline in global trade inthe fourth quarter of 2008 and into 2009,with devastating impact on African com-modity exports, particularly oil and mineralexports. Almost all the commodity expor-ters unfortunately rely on very few com-modities for their exports. This lack ofeconomic diversification is endemic toAfrica, making it quite vulnerable to sud-den internal and external shocks.Examples of countries dependent on oilexports include Nigeria, Angola, andCongo Brazzaville, and those dependenton mineral exports include Zambia, SouthAfrica, and Botswana. The decline in thecommodity exports is attributable to bothquantity (sharp decline in global demand)and price (sharp decline in commodityprices).

The other channels of crisis transmissionhave been through the capital accountand the financial sector which is discus-sed in the next subsection. There hasalready been a sharp decline in privatecapital flows in response the negativeeconomic prospects of the region, as wellas increased uncertainty and risk premiain the debt markets. In fact, accordingthe World Bank, net capital inflowsshrank to about $ 36 billion in 2008, from$55 billion in 2007(5). The other channel

for crisis transmission has been the decli-ne or deceleration of remittances fromNorth America, Europe, and regionallyfrom South Africa, with rising unemploy-ment in the source countries. The WorldBank projects over that remittances willdecline over 4% in 2009. This is veryworrisome given that these remittanceshave been of similar proportions as thevolume of aid flows and of foreign directinvestments.

Thus, the collateral damage to Africa,particularly Sub-Saharan Africa, has beenenormous, and it is exacerbated by wea-kening tourism revenues, possibly dece-lerating, or even shrinking aid flows, asthe budgets of the main donor countriescontinue to be under tremendous pressu-re due the continuing global recession.The adverse consequences of the globalcrisis on Africa through the shrinkage oftrade flows, capital flows, remittances, aidflows, and the declining access to inter-national real and financial markets, etc.have a bottom-line consequence on theaggregate economic performance. Therecent IMF report on SSA projects only1.5 % growth in 2009, which is alsoconsistent with the World Bank’s projec-tion (see f.4.). These projections are notfar off from those estimated by institu-

8

(5)Global Development Fund Report, 2009, Table A. 16.

tions in Africa, including AfDB, UNECA,etc. At a disaggregate level, some eco-nomies, such as that of South Africa, areexpected to contract.

3.2. Financial sector payoffs,but now reversing

The recently impressive economic perfor-mance and in the results of the stock mar-kets are not accidental. These arepayoffs to extensive economic and finan-cial sector reforms that have taken placeover the last two decades. Financial sec-tor reforms have been particularly impres-sive. They included reform packagesspanning a variety of measures, such asinterest rate liberalizations, removal ofcredit ceilings, restructuring and privatiza-tion of state-owned banks, along withsupervisory and banking regulatoryschemes, promotion and development ofstock markets. The financial sectorreforms are also fueled by rapid improve-ments in global conditions and advancingtechnology connecting Africa with the restof the world. In particular, the develop-ment of the equity market sector rein-forces Africa’s growing commitment to thefinancial sector policy reform.

There are still many challenges, though.First, the African financial development

gap remains enormous relative to otherdeveloping countries (see Table 2). Basedon the indicators of financial development,it appears that the financial sectors ofmost African countries remain quiteunderdeveloped even by the standards ofother developing countries. In 2007, theliquid liabilities of financial sectors avera-ged about 30 percent of GDP for Sub-Saharan Africa (see Table 2). Looking atthe other regions, none of them had afigure less than 40 percent. In fact, thefinancial development indicator approa-ched or exceeded 50 percent in EastAsia, Latin America, South Asia, and theMiddle East and North Africa.

The other indicator of financial develop-ment is the extent to which credit is beingchanneled to the private sector. On thatscore, the financial development for Sub-Saharan Africa is even more discoura-ging. The average level of credit exten-ded to the private sector was 16.6 per-cent of GDP in 2007, whereas for theother developing countries, the financialdevelopment indicator ranged from 32.5to 43.9 percent. Moreover, we will seelater that financial development indicatorsbased on the depth and liquidity ofAfrican stock markets are also low forAfrica(6).

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(6)Allen, Carletti, Cull, Qian, and Senbet (2009) are currently engaged in a research program on the Africanfinancial development gap. They examine the factors that are associated with financial development in Africa

Second, from a functional perspective thefinancial systems remain inefficient.Financial systems provide functionsbeyond just savings/capital mobilization.For instance, the mere existence of banksis of little value if their primary activity isto merely purchase government securitiesand shun the provision of private credit. Ifso, banks no longer serve as informedagents or intermediaries on behalf of thesociety and build vital information capitalthat is crucial for an efficient allocation ofresources. In fact, such banks are enga-ged in dysfunctional financial intermedia-tion, and this is in part reflected in highinterest spreads prevalent in Africa.

In the same light, the stock marketsshould also foster liquidity provision and

relative ease for exit. Unfortunately, evenby the standards of other developingcountries, they remain thin and illiquid inAfrica. Except for the South African stockmarket, pre-emerging stock markets inAfrica are by far the smallest of anyregions, both in terms of the number oflisted companies and market capitaliza-tion (Senbet and Otchere, 2008). Themean market capitalization, as a percen-tage of GDP, was 32.72% (20.56%, exclu-ding South Africa) for the period 2000-2006, and it was much lower than, for ins-tance, that of Malaysia (147.5%), butfared well in comparison to Mexico(25.50%).

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Table 2: Positioning of Sub-Saharan Africa in World Financial DevelopmentPanel A: Liquid Liabilities/GDP

DEVELOPINGCOUNTRIESEast Asia & PacificEurope & Central AsiaLatin America & CaribbeanMiddle East & North AfricaSouth AsiaSub-Saharan Africa

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

34.5%43.7%28.4%

40.1%

56.7%36.3%24.4%

34.2%43.9%26.9%

41.7%

54.3%35.9%23.9%

35.7%46.0%27.8%

44.2%

55.3%36.2%24.3%

37.0%47.6%28.4%

46.6%

54.9%38.8%24.7%

37.6%48.0%29.3%

48.4%

58.8%39.9%24.6%

37.9%49.0%30.5%

47.0%

59.1%40.6%25.5%

39.9%51.0%33.5%

49.5%

63.4%42.4%26.5%

41.7%51.3%35.5%

51.5%

64.3%45.8%27.6%

41.5%51.8%36.3%

49.4%

64.7%47.7%28.5%

42.0%52.1%37.7%

48.7%

64.3%49.9%29.2%

43.2%49.6%40.3%

49.2%

70.3%51.7%30.9%

46.8%54.2%43.6%

55.3%

62.3%53.8%32.5%

46.8%58.2%42.8%

54.1%

71.5%55.1%29.7%

Panel B: Private Credit/GDP

DEVELOPINGCOUNTRIESEast Asia & PacificEurope & Central AsiaLatin America & CaribbeanMiddle East & North AfricaSouth AsiaSub-Saharan Africa

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

22.3%34.4%19.6%

29.9%

28.6%18.1%12.1%

22.3%35.4%17.7%

31.3%

29.1%18.9%11.7%

23.8%38.7%17.6%

33.7%

31.4%19.5%12.1%

25.3%40.6%18.2%

36.4%

31.5%20.7%13.0%

25.7%37.1%18.5%

38.5%

36.4%21.3%13.5%

25.2%34.5%18.2%

37.9%

36.7%21.4%13.9%

25.6%34.5%18.6%

38.4%

38.3%21.7%14.0%

25.7%34.2%19.1%

37.9%

36.6%23.3%14.1%

25.4%34.6%20.8%

34.6%

39.5%24.3%14.4%

25.7%34.9%23.5%

33.4%

39.0%26.7%14.6%

27.5%36.1%27.8%

33.4%

44.5%30.7%15.5%

30.4%40.3%34.0%

37.7%

35.2%34.3%16.1%

32.5%42.5%37.0%

40.1%

43.9%33.6%16.6%

Source: Adapted from Allen, Carletti, Cull, Qian, Senbet (2009).

More seriously, African stock markets arecharacterized by a low provision of liqui-dity based on standard indicators of tra-ding activity: the ratio of total value ofshares traded to GDP and the ratio oftotal value of shares traded to the totalcapitalization of the market. Table 3 pre-sents data for the financial developmentindicators, including those for stock mar-kets for the period 1995-2007. ForAfrica, the average stock market capitali-zation as a percentage of GDP, and theturnover ratios are 25.6% and 6.5%, res-pectively, whereas the correspondingfigures for the rest of the world are 52.1%and 34.1%. Thus, the average liquidity ofAfrican stock markets, measured in termsof the turnover ratio, is roughly 5 timesbelow the average for the rest of theworld.

The discouraging stories on market capita-lization and liquidity do not quite captureimportant new developments under way inthe African stock market scene. Sub-Saharan Africa has seen rapid growth inthe number of stock exchanges. Twodecades ago, there were only 5 stockexchanges in sub-Saharan Africa and 3 inNorth Africa. There are now around 20stock exchanges operating in Africa.Market capitalizations grew at a doubledigit rate over the period 1991-2006,reflecting new listings and market perfor-mance improvements (Senbet andOtchere, 2008). While liquidity still remainslow, it has gradually improved over the lastdecade. In fact, there has been improve-ments in the indicators of all financial deve-lopment, both the banking and the equitymarket sector (see Table 3).

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Source: Allen, Carletti, Cull, Qian, and Senbet (2009).

Table 3: Financial Development and Selected Determinants Africa versus the Restof the World, 1995-2007

World (Mean)Variable Africa (Mean)

Liquid liabilities / GDPPrivate credit / GDPStock Market Capitalization / GDPStock Market Value Traded / GDPLn(Population density)Natural resourcesReal GDP growth rateInflation rateCurrent Account balance / GDPKKM indexBank concentrationForeign ownership shareState ownership shareSecondary/Primary school enrollmentRoads / AreaUrban populationGeographic branch penetrationDemographic branch penetration

64.2%57.7%52.1%34.1%0.440.5

4.1%5.2%0.2%0.330.65

27.1%15.9%0.81%1.07

63.6%29.7616.51

27.5%17.6%25.6%6.5%0.090.154.8%9.3%-3.8%-0.540.81

44.4%13.3%0.330.21

36.2%7.972.86

Pre-crisis performance

The natural question is: are there gains tothose countries introducing the stock mar-kets? What has been the performancetrack record of African stock markets?Looking at the pre-crisis data, despite thechallenges they have faced in terms oflow capitalization and liquidity, Africanmarkets have performed surprisingly wellin terms of both absolute stock returnand on a risk-adjusted basis (Senbet andOtchere, 2008). The risk adjustment isdone through the standard Sharpe ratio,which scales an average excess stockreturn (in excess of a risk-free return) bythe standard deviation. For the period1990-2006 (pre-crisis era), the averageannual return was 38.5% in terms of localcurrency. The corresponding Sharpe ratiowas 0.54. How do they compare with theother emerging markets? Again usingMalaysia and Mexico as a benchmark(one country from Asia and one from LatinAmerica), the absolute returns in Africacompare favorably with these two coun-tries: Malaysia (9.32 %) and Mexico(31.5%), respectively.

The stock market performance remainsimpressive even when converted into dol-lar returns, with an average annual returnof 21.8% and the Sharpe ratio of 0.10.The dollar returns compare favorably withthose of Malaysia (22.97%) and Mexico(24.85%). However, the risk-adjustedmeasure declines sharply from 0.54 to0.10. This issue motivates a policy reform

discussed in the next section regardingthe risk stemming from currency fluctua-tions in Africa. African currencies arerarely hedged and there is a dearth ofhedging mechanisms.

African stock markets hit bythe global crisis

The performance track record of Africanstock markets has been impressiveand these markets represent largely unex-ploited opportunities for global investors.How do these markets farein this global economic crisis? Well, therehas been a meltdown of major stock mar-kets globally (see Figure 2). The declinein equity wealth around the world is stag-gering, and in trillions of dollars just in theUSA alone. The stock markets declines in2008 were 37% in the US, 38% in LatinAmerica, 43% in Japan, and 51% inChina. European stocks declined 38.5%.

It is now logical to look at the extent towhich African stock markets have perfor-med even in face of the global crisis.Initially the US market got hit severely bythe crisis, but it spread around the globe,with massive stock sell-offs. African stockmarkets were not immune, and they expe-rienced sharp decline in the face of theglobal crisis. In particular, those marketswhich were relatively more integrated intothe global financial economy got hit first,including South Africa, Egypt, Mauritius,Ghana, Nigeria, and Kenya. As shown inFigure 2, the corresponding 2008 marketdeclines for selected markets were as fol-

12

lows: Nigeria 59%, Egypt 55%, Mauritius49%, South Africa 33%, and Kenya 31%.

Has the crisis changed the positioning ofAfrican stock market performance relativeto other emerging economies? Withoutthe benefit of looking at the full sample of

emerging economies, using Mexico andMalaysia as a benchmark, Table 4 showsthat African stock market returns, both inabsolute and on a risk-adjusted basis,fare better relative to these two countriesin the crisis period. While the marketsexperienced negative returns in 2008,

13

Figure 2: Market Meltdown Around the Globe

Crisis Performance for Selected African Countries (2008)Nigeria -0.59Egypt -0.55Mauritius -0.49South Africa -0.33Kenya -0.31

they were however generally less negati-ve than those of Mexico and Malaysia. Asimilar pattern is observed when the per-formance is measured in terms of avera-ge monthly returns and the corresponding

Sharpe indices. The Sharpe ratios wereless negative or comparable to the twoemerging countries. However, it is hardto generalize, given the small sample andjust one year of crisis data.

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Table 4: African stock markets performance in crisis

Panel A: Buy and hold returns

Country Mkt.Cap/GDP*2007

% Returns2007

% Returns2008

EgyptGhanaKenyaMauritiusMoroccoNamibiaNigeriaSouth AfricaTunisiaMalaysiaMexico

10916458910310523001518045

0.620.230.041.000.340.410.630.090.090.270.08

-0.55-0.13-0.31-0.49-0.24-0.04-0.59-0.33-0.03-0.43-0.39

Country2007 2008

MeanMonthlyReturns

Sharp Ratio Sharp RatioMean

MonthlyReturns

EgyptGhanaKenyaNamibiaNigeriaSouth AfricaMalaysiaMexico

0.050.020.000.030.050.010.020.01

0.620.200.070.380.680.100.320.25

-0.06-0.01-0.04-0.01-0.07-0.03-0.05-0.04

-0.71-0.09

--0.06-0.79-0.25-0.60-1.08

*Figures for 2008 are not available **The measures are calculated for countries for which data are available.Source: Senbet and Otchere (2009).

Panel B: Mean monthly returns and Sharp ratio during the financial crisis period**

It is also interesting to visualize theimpact of the global crisis on the marketvolatility in Africa. Figure 3 shows thatvolatilities measured from monthly returnsshow a decline over the last decade priorto the onset of the global crisis. However,as expected they spiked during the crisisperiod.

Again, this is one more indication thatduring the pre-crisis era the African financialsector, at least in the form of the equity sec-tor, had been performing well with increa-sing stability. Again, these payoffs havebeen due to the extensive reforms that havebeen undertaken, but now the gains arethreatened by the current global crisis.

15

Figure 3: Volatility Spikes for Selected African Countries

0

0,05

0,1

0,15

0,2

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Ret

urn

Vo

latil

ity

Year

Cumulative monthly return Volatility

Egypt Ghana Ivory Coast Kenya

00,020,040,060,080,1

0,120,140,160,18

Vo

latil

ity

Year

Cumulative Monthly Return Volatility

South Africa Tunisia Zambia Mauritius

In the following sections, we will discussthe longer term policy responses andreforms. We will begin with the role ofAfrican global partners in coping with theimpact of the crisis and Africa’s positio-ning in global financial reforms moving-forward. We will then discuss Africa’sown responsibilities and catalogue aseries of long-term reforms that may miti-gate the severity and frequency of futurecrises in Africa and/or the impact of crisesoriginating from outside Africa.

4. Africa and GlobalResponsibility

When the financial crisis began, therewas a sentiment that Africa will be spa-red, since most African countries are notintegrated into the global financial econo-my. This sentiment was short lived. Solong as African countries have real sectorlinkages with those countries which areintegrated into the global financial econo-my, the crisis gets transmitted throughthe real sector. That is exactly what hap-pened to Africa and low income coun-tries. As mentioned earlier, there hasbeen a sharp contraction in trade flows,investment flows, remittances, with theresultant negative impact on the econo-mic performance, and the threatening ofthe impressive gains that Africa hasachieved from two decades of genuinereforms.

Thus, Africa is caught up in the globaliza-tion of damage from the crisis. What isdisturbing is that there is no commensura-te globalization of resources to repair thisdamage and avoid further decline. Infact, enormous resources to the tune oftrillions of US dollars have been commit-ted as bailout and rescue packages bythe advanced countries. Africa and theother low-income countries lack suchresources. Is there an economicallysound rationale for globalizing resourceswhen dealing with this global crisis? Inparticular, what shape should this take inthe case of Africa? How do we promotethe voice of Africa in the evolving processof global financial reforms?

4.1. Short-term mitigation of collateral damage to Africa

As discussed in the earlier section, thecollateral damage stemming from the glo-bal crisis has been devastating to Africa.Sadly, this came about at a time whenmany African countries have embarkedinto a growth path close to the rate expe-rienced by the Asian tigers. Not acciden-tally, these gains were achieved as aconsequence of extensive economic andfinancial sector reforms that have beenundertaken. The global crisis is on theverge of derailing all these gains and pre-venting Africa from its rapidly rising contri-bution to an engine of growth for the enti-re globe. Consequently, there is a global

16

responsibility for helping mitigate the col-lateral damage so as to restore, or evenaccelerate, Africa’s growth momentumprior to the advent of the crisis. This is, infact, mutually beneficial.

Should Africa participatein the global stimulus plan?

By the end of November 2008, globallyabout $2.6 trillion dollars were used tobail out banks and other financial institu-tions, and to stimulate growth. In addi-tion, there were $2.7 trillion loan guaran-tees(7). More recently, the USA has com-mitted an additional stimulus package ofabout $800 billion and is very likely tocommit more resources to clean up thetoxic assets and to restructure banks.

So far the bailout and stimulus resourceshave been committed only on a nationalbasis. The global crisis itself makes itclear that countries should not be paro-chial and just nationally- focused. Forgood or bad, things that happen elsewhe-re matter. There should be a coordinatedglobal stimulus to spur global growth, andAfrica should be part of that stimulus plan.In fact, this is now an opportune time for

African countries to invest in infrastructu-re, health, education, energy so as the sti-mulate the economy toward recovery andinvestment, the aim being to enable Africato get back to its growth path in the future.It will then benefit the global economy asa vibrant new source of engine of growth.Thus, Africa matters from a globalmacroeconomic point of view, and the roleof the global partners in helping resolveAfrica’s current crisis is not a moral one. Itis a mutually beneficial economic opportu-nity(8).

The international institutions, particularlythe World Bank and the IMF, should playa vital role in coordinating such a globalstimulus plan and communicating crediblyand forcefully the beneficial conse-quences of rehabilitating African coun-tries. As the Africa growth dividend to theglobal economy can be beneficial, theadverse consequences of global neglectwould go beyond Africa’s misfortunes.The collapse of Africa and other low-inco-me countries can impose serious counter-collateral damage on the globe in theform of civil unrest and even wars, as nowmillions get thrown back into absolutepoverty; moreover, as more states fail,

17

(7)BW (12-1-08).(8)Some may argue that Africa matters little to the global economy, because its current contribution to the global

GDP is low. This thinking is static and ignores the dynamic nature of the globe as we mover forward. As thegrowth of advanced economies and emerging economies slows, there is a sleeping giant in Africa that wouldaccelerate into a material contribution to the engine of growth of the globe, should the pace of the more recentgrowth performance continue. Unfortunately, this momentum is being derailed by the current crisis.

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they become hotbeds for terrorist activi-ties which are global.

The cost to the advanced economies ofAfrica’s share of global stimulus is ratherminiscule and it should only be a tiny frac-tion of the trillions of dollars that are nowcommitted around the world. In that res-pect, the proposal from the World BankPresident, Robert Zoellick, to set up a“vulnerability Fund” funded by a tiny frac-tion of the global stimulus funds is a goodidea and should be welcome as a mutual-ly beneficial arrangement. Under the pro-posed fund, rich countries set stimulusfinancing for their own countries, theywould set aside an additional 0.7 percentto help stabilize poorer countries. Theresources will be channeled through theWorld Bank, the IMF, or the UN.

Finally, it is worth noting that Africa ispositioned better to cope with the crisisthan any other time in the past due to theextensive reforms of the past twodecades. However, it is dangerous to becomplacent, since there are many unk-nowns moving forward, including theextent to which the current round of globalstimuli yield positive results, the uncertain-ty about international investor confidence,and the crowding out of the debt marketsby the other advanced and emergingcountries, which are themselves in acuteneed of capital. Thus, a fiscal stimulus,while it may have drawbacks from a

macroeconomic stability standpoint, in theshort term, can help boost domesticdemand and safeguard growth in view ofa drastically weak external demand.

Building capacity for the lenderof last resort and “investor of lastresort”

The participation of Africa in the global sti-mulus plan is important for stimulatingAfrican economic growth. This will be apositive news for the real sector. On theother hand, the issue of financial sectorstability cannot just be addressed througha fiscal stimulus alone. Looming aheadare shrinkage in capital flows to Africadue to increased risks premia, a narrowedaccess to foreign debt markets and theincreased cost of capital. In addition, thecontinuing economic crisis weakensdomestic banks and financial institutions,including those “too big to fail”, relative tothe size of the economy, with the definiteprospect of systemic failure. However,Sub-Saharan Africa lacks the resourcecapacity to bailout out such institutionsand stabilize the banking/financial system.In other words, it lacks capacity to serveas “the lender of the last resort”, andmore importantly, as “ the investor of thelast resort”.

High-income country participation wouldbe needed to build such capacity. Forinstance, an African country may wish to

inject capital into a viable but undercapita-lized bank in exchange for “equity” orother instruments, partially nationalizingthe bank. This is in accord with what isgoing on in other advanced countries; butthe lack of resources would make it diffi-cult for the government to participate inthe financial sector so as to restore confi-dence and unfreeze the credit market.However, global participation in therescue plan through some kind of govern-ment facility, or even sovereign funds, canenhance the African country’s capacity toserve as an “investor of last resort”. Anequity participation through partial foreignownership of the banking system may becontroversial, but it is a short-term under-taking. As the economy recovers and thesystem stabilizes, both foreign andgovernment interests would be let tounwind. Alternatively, the resource sup-port for loan guarantees can be structuredas a guarantee scheme whereby therepayment is conditioned on future reco-very.

Thus, global intervention on behalf ofAfrica is mutually beneficial and shouldbe thought of in the same manner as bai-ling out the large financial institutions glo-bally. The benefits to the globe arisefrom the potential benefits of global diver-sification afforded to international inves-tors (see, for instance, the positioning ofAfrican stock markets in the global risk-reward ratios) and the positive spillover

of Africa’s economic growth to the rest ofthe world.

No one knows how severe the recessionis going to be in the advanced econo-mies, and even the extent to which themassive government interventions yieldthe desired outcome. This is an unchartedterritory since at least the GreatDepression. The magnitude of the collate-ral damage to Africa is still unfolding andyet unknown, but let us be clear that itwould be enormously costly unless thereis a coordinated global intervention

Aid flows and concessional financing

With a rapidly expanding country clientbasis stemming from the global financialcrisis, the IMF is upsizing. It was downsi-zing only a few years ago as its clientbase dwindled. Its fortunes seem counter-cyclical. In fact, in an unprecedentedway, the crisis has given rise to the intro-duction of a new facility with presumableminimal conditions for countries withsound economic structure. Ironically,these are the same countries that haddisdained the IMF conditionalities on fis-cal spending and economic policies andopted out of IMF lending. On the otherhand, countries such as Hungary, Iceland,Ukraine, Belarus, Pakistan have beenaccessing the rational IMF facility to copewith the crisis.

19

It is now clear that the IMF resource basewill be enhanced. The question is by howmuch.

The enhanced resource base should bebeneficial for Africa, particularly if Africaand low-income countries have a say inthis newly emerging global financial order.Africans and friends of Africa shouldstruggle to make sure the Fund has awell articulated objective that is consistentwith the maximization of the global socialwelfare, as opposed to “being captured”by the few powerful countries.

The increase in the IMF resource baseshould not work against the aid flow com-mitments from G7 and OECD countries.These commitments should be honored,and even enhanced. Again, at the risk ofrepeating, the aid flows should not just beviewed as “handouts”, but rather asinvestments in the region to get back intoa grow path and shelter from despair,poverty, civil unrest, and hence collateraldamage to the rest of the globe. This isalso one area that Africa-based multilate-ral institutions such as UN ECA and AfDBshould play a role in coordinating regio-nal efforts for Africa to cope with the cri-sis.

4.2. New global financial order: Africahas a stake in what the rest of theworld does

The current financial crisis and policy res-ponses bring home the fact that the socie-ty as a whole has a stake in what privateinstitutions/firms do. It also shows thatAfrica has a stake in what the rest of theworld does. There is now a growing reco-gnition for policy reforms to be globalizedor globally coordinated, and African coun-tries should be allowed to actively partici-pate in the design of these reforms. Inparticular, they should have a seat at thetable of the evolving new global financialorder(9).

The IMF is likely to emerge as a centralplayer both in policy responses to crisesand financial system reforms moving-for-ward. For sure, as witnessed in the mostrecent G20 London summit, the morepowerful emerging economies such asChina, India, Brazil, and South Africa willbe gaining more say in any redesign ofthe governance of the IMF, but the low-income countries should not be left out.Otherwise, they will continue to be bys-tand victims of the excesses caused byinstitutions in the more powerful countries,

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(9)Some radical proposals are currently floating around, including a proposal in favor of the establishment of aWorld Finance Organization (WFO), along the lines of WTO. There is a call for a global financial regulator, anda reevaluation of the Basel II Accord and the risk models that are used by banks and rating agencies. There is areevaluation of the existing international institutional arrangements.

as clearly demonstrated by the currentglobal crisis. In addition, in moving for-ward, African countries should be full par-ticipants in the design of oversight andregulation mechanisms of globally syste-mic financial institutions.

One of the most glaring regulatory gapshas been the lack of oversight of systemi-cally critical institutions and companies,as amply evidenced by AIG in the USA, agigantic insurance company, and shadowbanks such as Fannie Mae, which havebeen outside the conventional bankingregulatory schemes. In the face of weak,or even non-existent, regulation andoversight, such companies undertookexorbitant and complex risks which werenon-transparent. Their failure broughtdown the entire global economy. Theseissues are now at the heart of the G-20agenda. Thus, government/regulatoryfailure in one large country or one regioncan adversely affect other countries andother regions, including Africa. Whyshouldn’t then Africa have a stake and asay in the redesign of the global financialorder and regulatory regimes? Moreover,Africa and other LICs have a stake in thepolicy reforms that are being implemen-ted in the advanced countries, since ill-designed reforms and oversight mecha-nisms lead to a genesis of unrestrainedlarge and globally interconnected institu-tions.

5. Africa and Its OwnResponsibilities: GettingHouse in Order

While it is desirable, even necessary, forthe rest of the global village to helpaddress the severe challenges facing thelow-income African countries, this is nosubstitute for Africa’s own responsibilities.Africa also needs to get its house in orderto move forward.

The banking system in Sub-SaharanAfrica is sound by the standard measuresof leverage, and it is not currently in asystemic crisis. The African banks havenot been exposed to the US housing mar-ket through mortgage-backed securitiesthat are at the root of the global crisis.However, the continent’s banking system,and the entire financial system, facesserious vulnerabilities, as the global crisisis likely to get prolonged. Many banksare foreign-owned and hence exposed tothe continuing financial trouble of parentinstitutions. Moreover, the economic crisisreduces the debt servicing capacity ofbank borrowers, with an increasing risk ofbanks going under. Therefore, the pros-pect of a crisis hitting the Africa’s bankingand financial system is real. In fact, asdiscussed earlier, the African stock mar-kets are already hit severely. This is parti-cularly costly for countries with largerstock exchanges, such as South Africa.

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Thus, while going forward, African coun-tries should have a system of mecha-nisms for crisis resolution (e.g., recapitali-zations of banks) and policy/regulatoryreforms to help prevent future crises. Thecrisis resolution mechanisms can actuallybe applied preemptively to the bankswhich are identified as vulnerable througha stress test. This will help mitigate thecost of responding to the crisis, andcontribute to the stabilization of the ban-king and financial system.

Below is a catalogue of policy reforms. . 5.1. Building infrastructure for crisis

resolution

Policy responses and reforms triggeredby a financial crisis should have twopillars: crisis resolution mechanisms andmechanisms for the prevention/mitigationof future crises. While the banking systemin Africa is not currently in crisis, it hassignificant vulnerabilities as the global cri-sis gets prolonged. The system has signi-ficant exposures to global banks, whichare now in trouble and are facing theadverse consequences of the rapidlyweakening domestic economic perfor-mance, leading to the impairment of debtservicing capacity of borrowers(10).

So it is high time African countries put inplace efficient response mechanisms torehabilitate the banking/financial system.The process of rehabilitation should alsotake a longer view so that the appropriateresponses to the current crisis may beused for, or adapted to, future shocks.

Below we look at a variety of mecha-nisms, including an outright market solu-tion, bailouts targeted toward institutions(banks), those targeted toward instru-ments (hard to price assets held by insti-tutions) and those targeted toward consu-mers (e.g., household mortgage borro-wers). Some of these mechanisms arecostly and may even be viewed “tooadvanced” for Africa, but again this viewignores the dynamism of the region as itwalks through the increasingly globalized21st century. Africa should avail itself ofbest practices in financial regulation andgovernance. Moreover, the continentshould position itself strongly in terms ofreforms ahead of a potential future reco-very of the global economy and theownership of its own growth path.

Can the market take care of itself?

The rationale that is often advanced for apure market approach is that the institu-

22

(10)See Gande and Senbet (2009) for more detailed analysis of the banking system vulnerabilities in low-inco-me countries.

tions that took irresponsible risk and hadbenefitted in the boom period should notbenefit from any government bailout. Weshould let the market take care of itself.This argument is not nonsensical!

To develop a market mechanism of crisisresolution, it is important to distinguishbetween financial distress and economicdistress. Institutions may be financiallydistressed in the sense that they areunable to meet their outstanding debt obli-gations, but they can be economicallyviable. Economically viable institutionsshould remain in business, but their liabili-ties should be restructured. In thisrestructuring, current equity gets wipedout, but the creditors basically end up witha newly structured institution/bank.Creditors (and the government, via insu-red deposits) become equity holders.Alternatively, a holding company canacquire all the securities (debt and equity)and recapitalize the institution, if need be.

Under market solution or workouts invol-ving the mortgage market, for instance,banks can write down mortgages andrestructure homeowner debt in a way thatallows the homeowner to continue to payand occupy the house. The institutioncontinues to function as a viable entity aslong as there are productive/profitableopportunities. Viable institutions will lend

to each other. On the other hand, if aninstitution is not viable, it will fail bothfinancially (goes bankrupt) and economi-cally (goes out of business). The marketself-corrects by allowing the strong to sur-vive and the weak to fall.

Can the market handle financial distressby itself? For market solution to work, themarkets have to be well-functioning.There should be informational transparen-cy, and market prices need to be rationaland panic-free. The current environmentdoes not appear conducive to a marketsolution. There are opaque securities withdistorted prices. The systemic nature ofthe crisis accompanied with the crisis ofconfidence impedes free market transac-tions. This market failure can be resolvedthrough an appropriate and temporarygovernment intervention.

Direct capital injection into banks:target institutions

Under this approach, banks and bankholding companies are targeted for directcapital injection. The approach requiresthat viable but undercapitalized institu-tions be correctly identified. Also, theplan targets institutions rather than ins-truments, and it attempts to address thecapital and credit crunch. The rationalefor capital injection (and government

23

invention) is that, although these banksare viable, they face stress due to mar-ket panic, resulting in liquidation eventhough there is no fundamental reason toliquidate.

This mechanism of government interven-tion should be conducted in a manner tominimize cost to the taxpayers. Thegovernment can take a partial ownershiptypically in the form of preferred stock.The government can also hold an instru-ment that allows it to have an option toconvert into the bank stock in the form of“warrants”. If the credit market unfreezesand the economy recovers, there is anopportunity for the government to profitfrom its preferred stock or warrant hol-dings. As explained later, the warrant fea-ture has the added feature of producingthe right incentives for bank risk-taking.Warrants held by the government create adisincentive for excessive risk-taking andhelp stabilize the banking system.

Investment in liquidity and pricediscovery: target instruments

Under this approach, the governmentinvests in securities rather than, or inaddition to, injecting capital into banks.The government is presumably deep poc-keted and a patient investor. It can buyand hold assets and resell only when

home prices stabilize. Banks gain imme-diate liquidity and credit markets revive. Ifthe plan succeeds, it prevents panic andfire the sale of assets held by the banks.For instance, large institutions and bankshave “toxic” securities which are not liqui-dity.

The goal is to find market valuations thatare free of discounts for panic or dis-counts for the ill-health of the selling insti-tution. In fact, the initial Paulson bailoutplan in the USA targeted asset purchasebut it did not materialize due to a host ofincentive issues, including incentives forbanks to try to sell the worst assets at thehighest price possible. There is now atalk about stimulating private-public part-nership in achieving price discovery, butthe plan is yet to be announced.

Government sanctioned workout:target consumers

When the market solution fails, thegovernment can step in and facilitate aworkout between the borrowers (consu-mers) and the lenders (banks). Using themortgage market as an illustration, underan alternative plan, home-owners receivedirect subsidy from the government orhave concessional loans. The modifica-tion of repayment terms include thereduction in interest rates, principal

24

amounts, lengthening maturities, andother similar features. This plan has thepotential to prevent foreclosure and provi-de broad stimulus for the housing market.This is much welcome, since foreclosureare costly to the lender, as well as theborrower. Also, they adversely affectneighborhood house prices. This systemis a variation of the restructuring by theUS Federal Deposit InsuranceCorporation (FDIC).

The bottom line is that if fair price disco-very is needed, the government shouldgive incentives to private capital to enterthe initial auctions. If liquidity is neededfor credible exit, the government shouldalso pay special attention to the after-mar-ket liquidity of what is purchased at theauctions. Otherwise, the government willbe forced into a lengthy buy and holdstrategy and become the “owner” of lastresort rather than a lender of last resort.

5.2. Should banks be renationalizedin Africa?

There has been a widespread privatiza-tion of state-owned enterprises in Sub-Saharan Africa in the wake of the extensi-ve economic forms that have taken placein the region. This is particularly welcome,given the available evidence that privati-zed firms generally outperform state-

owned enterprises. Consequently, theconventional wisdom for the state owner-ship of business enterprises, particularlybanks, is being challenged.

Capital injection into banks in exchangefor government holdings of claims on thebank is tantamount to partial nationaliza-tion. This may show a defeat of a marketsystem, though. However, it should reallybe viewed as a temporary rescue measu-re in the face of market failure. If doneright and if the government exits (andreprivatizes) at the right opportunity, therescue measure may help restore a wellfunctioning banking system.

“Bad bank”, “good bank”, and exit

There is a successful precedence. TheSwedish government nationalized itsinsolvent banks in 1992, but it subse-quently reprivatized them after a clean-up.The Swedish restructuring agency actual-ly outsourced the clean up process to pri-vate bankers and managers, and the pro-cess was smooth. The Swedish model isnow in the works even in a large andmore complex financial environment suchas in the United States. Many venerablefinancial institutions and banks in theUnited States are now partially nationali-zed, and they include such institutions asCitibank, Fannie Mae, and AIG. The

25

remaining question, of course, is to knowwhether the Government will exit in anorderly manner.

The Swedish model is easier to apply tosmaller and plain vanilla banking systemssuch as in Africa. However, certain proce-dures need to be followed for the renatio-nalization process to work and restoreconfidence in the banking system. Oncethe insolvent banks are identified, theyshould be nationalized at the same timeso as to avoid panic from a piece mealapproach. Taking over a bank in asequence in a failed system will have anegative spillover into the entire system.Also, upon government takeover of theseinsolvent banks, bank equity will be wipedout, but other claimholders are paid off inpecking order with depositors first in line.

Moreover, the clean up process is anopportunity to break up large banks whichare concentrated and too big to fail. The“bad” assets of the insolvent banks can besold to the private investors and/or aggre-gated to a “bad bank” owned by thegovernment. The government will then exitat an appropriate time by reprivatizing nowsmaller but healthy banks with “good”assets, while eventually liquidating the“bad bank” in an orderly manner. This pro-cess is likely to result in even a reformedbanking system which is well capitalizedbut smaller and less likely to be systemi-

cally critical so as to bring down the entiresystem if it fails and engenders crisis.

Resist the temptation for continuedrenationalization

Renationalization without a clear strategyto exit into reprivatization creates a temp-tation to hold onto banks post-crisis. Thistemptation is, in part, fueled by the tradi-tional thinking that state-owned banksserve underserved markets, particularlyrural areas and small enterprises.However, the conventional view is contra-dicted by the emerging evidence. Underat least one available piece of evidence,state ownership is associated with lessfinancial development, poor banking per-formance, and less growth (Barth, Caprioand Levine 2001).

Africa has experienced a sharp decline inthe state ownership of banks in recentyears, although some countries (e.g.,Ethiopia) continue to resist bank privatiza-tion altogether. Unfortunately, the perfor-mance outcomes of bank privatization inAfrica are mixed and not that encouraging(Senbet and Otchere, 2006). The eviden-ce suggests some deterioration in theasset quality, credit quality, and profitabili-ty of the privatized banks. Even thosewhich were privatized through the stockmarkets under performed based on stockmarket data. This is, of course, a general

26

picture and individual cases may be diffe-rent. Thus, the results suggest a possibi-lity that there have very limited gains frombank privatization in Africa.

The African evidence on the performanceeffects of bank privatization needs furtherexamination, since it is inconsistent withthe evidence emerging from other regions(Clarke, Cull, and Shirley, 2004). A coupleof factors have been suggested to explainthe puzzle. The first explanation is thatweak quality of data on African stock mar-kets may have made it difficult to getsharper results.

The second explanation has more cre-dence and it is rooted on the prevalenceof partial bank privatizations in Africa,which still leaves banks vulnerable tocontinued government intervention intheir functioning. There is a strong pieceof evidence supporting this view basedon data from other regions. Souza,Megginson, and Nash (2001) provideconvincing evidence that the performanceof privatized banks improves with lessgovernment retention of shares. Morerecent evidence corroborates this, sug-gesting gains from privatization are insi-gnificant under partial privatization evenwhen the government has a minoritystake (Clarke, Cull, Shirley, 2004). Thecollective evidence has a policy implica-tion for a well functioning banking sys-

tem. The continued ownership (partial) ofthe government in privatized banksshould be abandoned.

5.3. Reforming banking regulation

The current crisis provides an opportunityto rethink about the regulatory schemes ina comprehensive way. What is broughthome is the build-up of risk exposures notonly by banks but “shadow” banks stem-ming from regulatory gaps and distortedincentives of decision-makers in the ban-king and the overall financial system.Although these issues are now geting glo-bal attention, African countries shouldalso put in place the appropriate mea-sures for its moving-forward so as toreduce both the frequency of future crisesand their potential severity.

Design of incentive compatibledeposit insurance scheme

The purpose of explicit deposit insuranceis to stabilize the banking system by redu-cing the risk of systemic failure. However,if a deposit insurance scheme is ill-desi-gned, it may produce the opposite effect.It can create incentive incompatibility pro-blems between depository institutions andthe regulator, which can increase the sys-temic risk and instability of a banking sys-tem (See Figure 4).

27

28

Figure 4: Bank Investments and Deposit Insurance

F = Bank deposit/debt obligationsT = Bank assetsΠ=Deposit insurance premium q = Probability of success; 1-q = Probability of failure

Bank collects deposits Bfrom the depositors. Paysinsurance premium to the

FDIC

Regulator

Beginning period

Bank pays min (F, A) to the depositors and Regulator pays max (0, A-T)

Π

IntermediateInvestmentOpportunity

SafeInvestment

RiskyInvestmentEnding

A = L A = I

1 - q

A = H

q

As Figure 4 shows, the bank collectsdeposits and channels them into eitherrisky investment opportunities (loans tothe private sector) or riskless opportunities(holdings of government securities orloans to the government). With depositinsurance, depositors themselves face norisk, since the risk is transferred to aninsuring agency. The insurance agencypays a shortfall (F-A in Figure 4), and thebank owners walk away. However, thebank pays the full amount of the depositobligations (F) under favorable economicconditions, and the insurance agency paysnothing. The deposit insurance has a fea-ture of what is known as a “put option”,whereby the government writes it and thebank holds it. This creates incentives forbank owners to gain by undertakingexcessively high risky asset portfolios..Thus, deposit insurance is a double-edgesword, and this is supported by the evi-dence in Cull, Sorge, and Senbet (2005).They study the impact of a variety ofdeposit insurance schemes around theworld on financial development and stabi-lity of the countries adopting them.Countries with high quality regulation andinstitutions achieve stability, but depositinsurance is destabilizing to financial sys-tems with weak institutional and regulato-ry regimes.

Finally, there is a continuing debate onthe use of deposit insurance. Some have

proposed an outright abolition.Unfortunately, as witnessed during thecurrent crisis, even when there is no for-mal insurance there is an implicit insuran-ce. Banks or bank-like institutions, whichare deemed too big to fail or too intercon-nected to fail, are being bailed out to mini-mize the adverse impact of the crisis.There is no question that deposit insuran-ce, implicit or explicit, can play a poten-tially useful function in enhancing the sta-bility of financial institutions, if it is proper-ly designed. There is a lesson for Africa.It is even more important for the Africancountries and shaky financial institutionsthat such insurance schemes be incentivecompatible and help reduce excessiverisk-taking and financial sector instability.

Improving capital regulation

The foregoing discussion argues thatdeposit insurance is insufficient for thestability of the banking system, and whenit is ill-designed it can actually have a per-verse effect and banking system instabili-ty. Banking regulation should have appro-priate capital standards to reduce excessi-ve risk-taking by bank owners. The bankrisk distortion is a decreasing function ofbank capital, and an increasing function ofbank leverage. However, capital regula-tion is also limited in its effectiveness.Unless the bank is regulated to be totally“riskless”, there is still room for bankowners to engage in risk that is socially

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suboptimal (albeit at a lower level). Ofcourse, regulating banks to a zero-risklevel is socially suboptimal, since itdeparts from a socially optimal level ofbank value. The optimal level of socialrisk is not zero!

Capital standards should track differencesin the bank risk opportunities and theyshould not be “one size fits all”, Differentbanks are likely to maximize the sociallydesirable level of bank value at differentlevels of risks, and capital standardsshould be differentiated to reflect that.This has implications for global capitalstandards as well. Capital regulatoryrules should not be standardized at a uni-form level, but should be country-specific,and even bank specific. Finally, the cur-rent crisis makes it clear that there shouldbe supervision and monitoring of the liqui-dity position of banks, particularly a mis-match between short-term bank liabilitythe long term assets that are financed, inaddition to the capital position.

Regulating shadow bankingand systemic regulation

The current system of capital regulation isaimed at limiting bank risks individually inisolation, but it leaves open for banks andlarge bank-like institutions to take risksthat build up aggregate and systemicrisks. The presence of implicit guaran-tees for failure of systemically critical insti-

tutions gives perverse incentives for finan-cial institutions to undertake concentratedand pro-cyclical risks so as to maximizetheir chances of being bailed out (Gande,John, and Senbet, 2008).

a. Regulating shadow banking

The current crisis has exposed that finan-cial systems breed institutions which arecomplex with functions similar to whatbanks do. Traditional banks basicallyaccept deposits and lend to transformdeposits into longer term assets. Theyborrow short and lend long. In addition,the long-end is less liquid than the short-end. It turns out that there are non-banks, such as money market funds,investment banks, hedge funds, whichperform very similar functions but in amore complex and non-transparentfashion. These “shadow” banks havebeen outside the banking regulatory regi-me. As financial systems develop inAfrica, there will be more of “shadow ban-king”, and this is now an opportune timeto think about the disciplinary mecha-nisms.

Apart from unregulated shadow banks,there will be an emergence of systemical-ly critical or interconnected institutionsand entities that can hostage the entirefinancial and economic systems. Africaneconomies which are specialized in veryfew sectors are particularly vulnerable to

30

such systemic failures. The shadowbanks and systemically critical institutionsshould be brought under the same regula-tory umbrella.

b. On the design of systemic regulation

The current global crisis has revealed aserious regulatory gap for systemic risk.Moreover, financial institutions were ableto build up risks in a non-transparentfashion through usage of complex securi-ties which are often off-balance sheets.What is also disturbing is that systemicrisks have become globalized. The cur-rent capital standards are inadequate indealing with systemic risk. There is a gro-wing consensus for some type of syste-mic regulation, but the debate on how itshould be designed is unsettled.Systemic risk is easier to define thanmeasure. How do we measure, for ins-tance, the contribution of an institution tothe potential failure of the entire system?The input to such a measure should inclu-de size, interconnectedness, and com-plexity, and pro-cyclicality of risk-taking.Capital ratios will then be raised to reflectthis measure(11).

The pricing of deposit insurance is alsoanother instrument of discipline, but it is

harder to apply in the case of these enti-ties with implicit guarantees. With explicitinsurance, an explicit insurance premiumschedule can be designed as in the caseof regular banks. An alternative to char-ging a premium is for the government tohold warrant like claims on such entities,which may even produce incentive com-patibility by reducing the incentives forthese institutions to engage in excessiverisk that is damaging to society.

A variation of the warrant scheme is anestablishment of an institution similar to adeposit insurance corporation into whichsystemically critical institutions can pay apremium based on the implicit guarantee,conditioned on the measure of systemicrisk. This fund will then be tapped into bytroubled institutions in the event of thesystem failure, such as in the current cri-sis. If the guarantee is priced correctly, itwill have a disciplining effect on systemicrisk behavior.

Minimizing political capture:who regulates the regulator?

Designing an efficient regulation demandsa well-functioning banking regulatory

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(11)Banks in Africa can be both “too big to fail” and monopolistic. Size contributes to systemic risk, but also pro-duces a monopoly power which leads to inefficient intermediation and allocation of resources. The observedhigh spreads prevailing in many African countries are attributable to bank monopoly. Market power from mono-poly also translates into political power, as clearly pointed in a floor discussion at the April AfDB workshop(see the following subsection on political capture). Thus, An African regulator has to deal simultaneously withsystemic risk and monopoly power. As discussed earlier, the former can be dealt with stricter capital stan-dards, but the latter requires a set of measures for fostering competition in the banking system.

infrastructure with strong supervisory andmonitoring role for regulators. In particu-lar, the system should not allow for theregulators to be captured by the regulatedbanks and financial institutions. This isalso why partial privatization of bankingunderperforms relative to fully privatizedbanking (see the earlier discussion onbank privatization). Full privatization mini-mizes continuing government interferencein the functioning of the banking system.

Political capture can also arise in thecontext of resolving a crisis, where thetenure of politically connected but failingbanks is prolonged. A more efficient reso-lution approach calls for speedy mea-sures, including speedy closure of failedbanks or restructuring of their balancesheets. The tenure of failed banks shouldnot be prolonged, since it simply transfersprivate losses to the taxpayers. Moreover,in a crisis environment, failed banks haveincentives to take even wilder risks anddestabilize the system even further.

5.4. Reforming stock marketregulation: A brief

Public confidence and informational effi-ciency through transparent and crediblefinancial disclosure rules are vital for thefunctioning of stock markets. Financialstatements should be trusted and transpa-rent about firms producing them. Theconfidence factor cannot be over-empha-

sized for Africa. Legislation alone cannotproduce confidence. We know there is noshortage of legislation in Africa. To fosterpublic confidence, there should be aneven playing field, with strict enforcementof laws and rules by a credible and inde-pendent judiciary and regulatory body.

The government should foster an environ-ment for strict enforceability of privatecontracts and the existence of accountingprocedures and disclosures. Thus, a wellfunctioning stock market system requiresregulatory schemes that promote, ratherthan inhibit, private initiative, and fosterinvestor confidence in the functioning ofthese markets. Consistent with best inter-national practices, the regulatory systemshould include a strong securities andexchange commission capable of enfor-cing securities laws, and capable of deve-loping appropriate rules.

However, it is tempting to over-regulatestock markets, and that should be resis-ted. It is never the job of the regulator todetermine what is best for the investor.The regulator should only create an envi-ronment in which the investor makes aninformed decision. Government regulationof stock markets should be more of anoversight over self-regulatory agencies,with such an oversight coming from, forinstance, the securities and exchangecommission, an organ of the government.Self-regulatory organizations, such as the

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stock exchanges, design rules for busi-ness and professional conduct of licensedmembers, and they build on the capacityand wisdom of individual inside the mem-ber firms. These individuals participate inthe stock market directly unlike govern-ment regulators who lack intimate know-ledge of the day-to-day functions ofincreasingly sophisticated markets.

5.5. Governance: overhauling bankgovernance and corporategovernance

Banking and financial failures arise notonly from regulatory gaps but also fromdistorted incentives of decision-makersand management. In a new order ofoversight of banks and the financial sys-tem, the government needs to monitorhow the incentives are structured. Thishas to be done without direct interferencein the functioning of banks and otherfinancial institutions. The added advanta-ge of monitoring of governance in thebanking industry is that it can be used indevising a more efficient and incentivizedregulation.

Bank governance and regulation:toward an incentivized regulation.

Banks are managed by professionals whohappen to have their own incentives thatmay be in conflict with the interests ofbank owners and the society at large.Their managerial behavior is influenced

by the way they are incentivized.Consequently, the incentive features ofbank management compensation influen-ce the risk-taking behavior of bank mana-gers. It is important that regulatory desi-gn takes account of the structure of bankmanagement compensation in place.

In fact, the incentive features of compen-sation can be used to design a more effi-cient and incentivized regulation. To seethis, consider Figure 5 which characte-rizes a specific bank management com-pensation structure with three compo-nents – fixed salary, bonus, and equityparticipation. If the compensation consistsonly of fixed salary, the bank manage-ment becomes excessively conservativein its decision-making so as to stabilize itsown compensation. However, the bankwill end up being managed at a level ofrisk that is socially suboptimal. If, on theother hand, the compensation consistsonly of equity participation, the interests ofbank management and bank owners arealigned. As discussed earlier, in an ill-designed regulatory environment, bankmanagement working in the best interestsof bank owners will engage in excessivelyhigh risk portfolios and lending. The bankgets managed at a risk level that is desta-bilizing to the system.

This suggests that there is an intermedia-te strategy of combining the three fea-tures of bank compensation which then

33

leads to the socially desirable managerialrisk level. John, Saunders, and Senbet(2000) show that, if deposit insurance ispriced to reflect the incentive features ofbank management compensation, it paysbank owners to precommit to a compen-sation structure that incentivize decision-

makers to stay at a socially desirablelevel of risk, and help achieve bankingsystem stability.

It is interesting to notice that compensa-tion incentives were silent in the regulato-ry schemes around the world until the

34

Figure 5: Incentive Features of Bank Management Compensation StructureSalary, bonus, equity participation: S,l, a

• Fixed salary S>0• Fraction α of the equity of the bank (alignment with shareholders) • Bonus λ (alignment with depositors) • When the bank is solvent (A-F>0), the first λ dollars of (A-F) is paid

as a bonus:F = Deposit/Debt obligations, A = Bank assets

advent of the global crisis. There is nowan increasing recognition that the mannerin which bank managers are compensa-ted should be central to banking regula-tion – and also to the oversight of theoverall financial system (see below).Hence, this is an opportune time forAfricans to consider adopting regulatoryschemes that are consistent with the evol-ving best practices triggered by this crisis.

Corporate governance andregulation

As financial systems develop in Africa, thecorporate sector should be moving to bestpractices in corporate governance. Marketsystems will not function properly withoutquality corporate governance. Althoughprivatization programs bring companies toa disciplinary force of the market system,corporate insiders may still engage in acti-vities harmful to capital contributors.Once investors lose confidence in corpo-rate governance, the company’s ability toraise funds and grow will be impaired.

Focusing on the internal mechanisms ofcorporate governance, getting governan-ce right requires (a) a well-functioningcorporate board and (b) a well designedcompensation structure that provides pro-per incentives for decision-makers. Thecurrent global crisis has again drawn

attention to the level and structure of exe-cutive compensation in the United States.There is a growing concern that someexecutive compensation plans might havebeen among the causes of the crisis byfostering a corporate environment ofgreed and aggressive risk-taking. Thisissue also came up in the wake of thecorporate scandals associated with theinformation technology bubble.

a. Executive compensation andgovernance reform

Misaligned incentives can distort invest-ment decisions toward more aggressiveand excessively risky, eventually leadingto the kind of crisis we are witnessingtoday. In fact, there was a dramatic rise inexecutive pay in the USA, leading up tothe burst of the bubble, both in absoluteand in relative terms. For the companiescomprising the S&P 500 index, the avera-ge CEO pay grew from $3.5 million in1992 to about $15 million in 2000.Relatively, this was about 500 times thatof an average employee compensation.In 1980, it was only about 40 times!(12)

The lion’s share of the increase in CEOpay came from the dramatic use of stockoption grants during the 1990s.

Overly generous compensation packagesand the widespread use of stock optiongrants may have created incentives for

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(12) Business Week (September 11, 2000).

aggressive risk behavior which is nowbeing partly blamed for the current crisis.Again, there is a lesson here for policyreforms in Africa. Properly designed, topmanagement compensation can serve asa key mechanism of corporate governan-ce with the potential to provide the rightincentives to perform in a way that maxi-mizes an enterprise value. The corporateboard has full authority to set the com-pensation plans for senior executives, andhence the policy reforms should get thecorporate governance systems right.

The executive compensation setting pro-cess should be transparent and should bedevoid of the influence of the executivesthemselves. Executives can influence theprocess in a variety of ways. In particular,they can dominate the nomination ofdirectors in the board compensation com-mittee. They can also exert influencethrough seats in interlocking boards.Therefore, one important reform of corpo-rate governance is a requirement for thecompensation committee of the board tobe totally independent. This independen-ce is achieved from appointing directorsoutside the company and with no direct orindirect relationships with the company.Moreover, there should be a majorityindependent overall board. In fact, board

independence is growing around theworld(13).

b. Adopting best corporate governancepractices

African countries should strengthen insti-tutions for corporate governance andadopt best international practices in termsof measures for the effectiveness of thecorporate board, executive compensationpractices, a system of disclosure rules,and increased protection of shareholderrights against controlling shareholders/management. It should be recognized,though, that best practices in corporategovernance require a separation of therole of the government as a regulator andbusiness operator, and fostering boardindependence through a majority non-executive directors. The growing consen-sus around the globe is that the corporateboard be independent of the chief executi-ve officer. Moreover, as discussed earlier,the compensation committee should becomposed of independent directors tobring transparency and prevent ill-desi-gned compensation structures that pro-mote aggressive risk behavior that leadsto instability and crisis. Finally, in the caseof African stock markets, the stockexchanges themselves, in their role as

36

(13)The transparency of the compensation plans is enhanced through disclosure rules requiring that all elementsof executive compensation, including retirement benefits and indirect compensation, be disclosed to the sha-reholders. There is also a growing movement for shareholders to vote on the equity-linked compensationplans, and this is one area of reform that African regulators may consider.

self-regulators, should establish stan-dards for listing of companies, consistentwith best governance practices.

5.6 Fostering market depth andfunctionality

African stock markets are still small andhave low trading activity (see Table 3).There are certain institutional factors thatimpede the liquidity of these markets.Institutional investors, as well as govern-ments which maintain minority stockhol-dings, are not active traders in the secon-dary market. Moreover, markets tend tobe dominated by a few large companies.Fortunately, though, these markets havebeen experiencing improvement both incapitalization (size) and liquidity. Theseimprovements have been in response toother improvements in regulatory andeconomic environments that the regionhas experienced over the recent past.However, more is needed. Below are twoavenues for increasing capacity anddepth of these markets discussed.

Exchange consolidationand regional cooperation

One important way to address the thin-ness and illiquidity of African stock mar-kets is market consolidation throughregional cooperation to pool and buildcapacity of these markets. Fortunately,there is a growing recognition for this, andsome efforts are already in place and

others on the way. The first such regionalmarket is the Abidjan-based Bourse régio-nale des valeurs mobiliéres (BVRM)which came into existence in 1998, and itserves the Francophone countries ofWest Africa, comprising Benin, BurkinaFaso, Cote d’Ivoire, Guinea-Bissau, Mali,Niger, Senegal and Togo. TheAnglophone countries of West Africa arealso contemplating establishing a regionalstock exchange under the ECOWASumbrella. Moreover, Kenya, Tanzania andUganda can be partners in forming anEastern region stock exchange. A similarpartnership is possible for a southernregion under the auspices of the SouthernAfrican Development Community (SADC).

Regionalization and exchange consolida-tion has an added advantage of accelera-ting the momentum of African integrationinto the global financial economy. Whileinjecting more liquidity into the markets, itallows regional companies to mobilizeboth domestic and global financialresources. There are certain prerequisitesfor market consolidation, and they includethe establishment of regional securitiesand exchange commissions, regional self-regulatory organizations, the harmoniza-tion of legal and regulatory systems, theharmonization of accounting reportingsystems, along with clearance, settlementand depository systems, as well as theharmonization of tax policies for securityinvestments.

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Promoting market-basedprivatizations

In view of the thinness of African stockmarkets, large-scale privatizations throughthe markets contribute directly to marketdepth through increased listing supply. It isencouraging that a growing number ofAfrican state-owned enterprises haverecently used the stock markets for privati-zation (Senbet and Otchere, 2006). Ingeneral, the stock market vehicle is animportant means of depoliticizing privatiza-tion programs, since it allows for price dis-covery, and hence makes it possible forlarge-scale privatization programs to befairly and transparently priced.

There are less obvious benefits in themarket-based privatization programs,though.First, state-owned enterprises arebrought into the domain of market discipli-ne and improved corporate governance.In the public domain, state-owned enter-prises lack effective governance mecha-nisms and face little competition. Privati-zing them and bringing them to the disci-pline of the stock markets should improvecorporate efficiency and performance.Second, local stock markets provide anopportunity for local investor participationthrough purchases of privatization shares.This helps alleviate some concerns aboutforeign grab of privatization assets.

Third, privatization programs through thestock market promote diversity in theownership of the economy’s resources,helping alleviate public concerns thatstock market serves just the few elite insociety. Finally, privatization through thestock market increases public awarenessabout the market through a creation offirst-time purchasers of shares, andotherinstruments through unit trusts. Unit trustsand/or institutional funds play a vital rolein large-scale privatizations. This sug-gests another reason for cultivating anenvironment for the development of insti-tutional funds that help promote widershare ownership.

5.7. Building capacity for oversight ofrisk and risk management

At the center of the global financial crisisis excessive risk which is fueled by exces-sive leverage. We got there as a result ofdistorted incentives for deliberate riskybehavior that garnered huge rewards inboom periods. However, that is not thewhole story. The risk exposures alsobecame so complex and intertwined thatthey became opaque and beyond ordina-ry capacity to restrain. As the good timesrolled, even the traditionally reputable ins-titutions took huge bets through excessiveleverage(14) .

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(14)Goldman Sachs, for instance, had $1 trillion of assets but supported only by a $43 billion equity by the endof 2007 (The Economist, October 18, 2008).

The lesson for Africa is straightforward,given the continuing commitment to builda well-functioning, dynamic, and innovati-ve financial system. Dynamism and inno-vation are risky. The solution is not toavoid risk but to develop capacity tomanage risk so that the system operatesat an optimal risk level. This requires get-ting two things right. First, there shouldbe a regulatory system and governancescheme that provides proper incentivesfor the discipline and management of risk.The earlier discussion pertaining to gover-nance and regulatory mechanisms, parti-cularly incentivized regulation, is intendedto help achieve this goal. Second, thereshould be sufficient capacity to unders-tand and manage risk.

Risk management capacityand talented financial manpower

Globally financial systems have becomeincreasingly innovative and sophisticated,and they will be even more with everadvancing technology. The advancedinnovation includes a variety of exoticsecurities and derivative instruments.Credit default swaps lead to the collapseof AIG and triggered financial crisisaround the world. The dynamism andinnovation is likely to continue hopefully ata more sober level, but they demand that

market participants stay abreast of suchadvances.

Innovative products and a variety of deri-vatives are getting their way into low-inco-me countries, including Africa. While theyare vital in terms of risk control and hed-ging, they can also be mismanaged andproduce explosive risks leading to finan-cial disasters that we are currently witnes-sing. Given that African countries arecommitted to a continuing financial sectordevelopment, including stock markets,even derivative markets, commensuratelythey should also be committed to develo-ping a talented financial manpowercapable of managing risk. Sufficientresources should be committed to impro-ve business school curricula in universi-ties and training programs in financialmarket institutions, such as securities andexchange commissions and stockexchanges.

The development of financial marketpower should be both for the banking andequity market sectors. The significance oftalented financial manpower can be illus-trated as follows. Lack of capacity to eva-luate credit risk is likely to produce twomistakes – unduly conservative lendingpolicy that minimizes private credit (andmaximize credit to the public sector) orunduly high-risk lending. Both are alloca-

39

tionally inefficient, and produce a malfunc-tioning or destabilizing banking system.Thus, building capacity for risk manage-ment and control is crucial for banks toperform their intermediation functions andacquiring information capital, and hencefor the development of a well-functioningand stable banking system.

Risk literacy and talented regulatorymanpower

Well-functioning financial systems demandwell-informed participants: investors,investment advisors, brokers, accountants,government regulators, and self-regula-tors. Like financial institutions, financialregulators should also understand the riskexposures that build up in the system, andthis is becoming even more important inthis increasingly complex and connectedenvironment. Therefore, literacy in finan-cial regulation requires literacy in riskmanagement and control. African univer-sity programs should be supplemented byspecialized training programs to producefinancial manpower and regulatory forcethat is appropriate for well-functioningfinancial systems.

5.8. Managing financial globalization

There are encouraging forces in place forAfrica’s integration into the global financialeconomy. There is growing integration ofworld capital markets, including those in

emerging economies, with increasingcapital mobility. Moreover, there are rapidadvances in information technologyconnecting Africa with the rest of theworld, with the potential to facilitate capitalflows. Thus, investors seeking the bene-fits of global diversification are now betterable to access African markets.

Financial globalization has mutual benefits

Financial globalization has mutual bene-fits for international investors and Africa.International investors take a global viewin their holdings of portfolio investments.Africa’s competitiveness in attracting inter-national capital depends on its role inimproving the global risk-reward ratiofaced by global investors. These improve-ments come in two forms. The benefits ofglobalization risk diversification depend onthe diversity in the economic cycles ofcountries. The available evidence sug-gests that such global strategies shouldinclude emerging markets, and even pre-emerging markets, such as those in Africa(e.g., Diwan, Errunza, and Senbet, 1993).

The second potential benefits of financialglobalization of Africa arise from marketreturn performance on a risk-adjustedmeasure as discussed earlier (seeSection III (3.2)). There is growing eviden-ce that African stock markets are genera-ting appropriate investment rewards foran acceptable levels of risk.

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Now we can also catalogue the potentialbenefits of financial globalization toAfrican countries. First, financial globaliza-tion improves access to diversified sourceof external capital, potentially reducingreliance on sovereign debt and official aidflows. Second, financial globalizationallows sharing of local country risks glo-bally, and leads to reduction of cost ofcapital for local companies. This leads toenhanced liquidity of the local market andcapital mobilization by firms in responseto the reduced cost of capital. The spillo-ver effect here is an improved economicperformance as projects, which previouslywere foregone due to lack of risk sharing,would now be adopted.

Third, financial globalization exposesAfrican financial systems to the best prac-tices and standards, and in turn puts pres-sure for reforms of the local financial sys-tems. Governments will be under greaterpressure to strengthen the rule of law,enforce contracts, and increase the growthof available information in response to thedemands of global investors. Financialglobalization will also lead to improvedaccounting disclosures, regulations, tra-ding systems and brokerage services.

Financial globalization has coststoo, but so does marginalization

Financial systems tend to go bust periodi-cally. Financial globalization exposes

African countries to volatility of the globalfinancial markets. This global risk exposu-re could then lead to large and suddenlyunfavorable swings in capital flows to theregion. The available evidence from otherregions of the world is that countries thatexperienced large capital flows sufferedcommensurately large and sudden out-flows. In the current global economic pan-demic, the countries most open to finan-cial globalization seem to be hit the har-dest. As we are witnessing now, the col-lapse of capital flows can be enormouslycostly, leading to credit crunch in the localeconomy.

Now, given the costs of financial globali-zation and the current global Tsunami, itis tempting to avoid financial globalizationaltogether. However, this is misguidedand short-sighted. First, as witnessedfrom the current global financial crisis,African economies cannot run away fromits effects even when they are not integra-ted into the global financial economy,since its adverse consequences can betransmitted through the real sector (e.g.,sharp decline in trade and direct invest-ment flows). Second, marginalization inthe global financial economy loses out onthe potential benefits of globalization (seeabove). Finally, when promoting financialglobalization, measures should also be inplace to mitigate the adverse effects, anddeveloping a deep financial system, inclu-

41

ding the stock market, is one of them.Moreover, there should be enhancedcapacity to manage risk.

Financial globalization:outsourcing financial systemdevelopment?

Should African countries bypass the chal-lenges of developing domestic financialsystems and just attempt to access globalfinancial markets to meet their financinggap? This seems a logical question inview of some large companies alreadycross-listing on the foreign exchanges.However, this cannot be a substitute fordomestic financial development. Well-functioning African financial systems,including the domestic stock markets, pro-mote domestic resource mobilization byproviding incentives and profitable optionsfor domestic capital to be retained. Giventhe massive financial capital flight fromAfrica over the years, the use of domesticfinancial systems to retain domestic capi-tal is highly desirable. Moreover, the exis-tence of a deep and well-functioningdomestic financial system is an importantchannel for integrating Africa into the glo-bal financial economy.

Building financial system/capitalmarket database and research

Despite the extensive political, economicand financial sector reforms that have

been implemented in Africa, negativeimages crowd out the positive in the inter-national news headlines. Images of war,famine, massive corruption, and violationsof human rights dominate the outside per-ception. The general perception, which isat odds with the fundamentals, is fueledby the monolithic view that Africa, particu-larly Sub-Saharan Africa, is a single “trou-bled” country. This information gap iscostly and penalizes an entire region bymasking the genuinely reforming coun-tries. It has adverse consequences onAfrican stock markets and the financialsystems in large, and the ability of thecountries to access outside debt countriesat favorable terms. This is partly reflectedin the low ratings concerning the credit-worthiness of Sub-Sahara African coun-tries relative to other regions (as shown inFigure 6/Table 5).

The ratings have displayed improvementover the more recent years, though, butthey are still very low, suggesting highcountry risk. Therefore, the informationgap surrounding African financial systemsin the eyes of global investors, as well aslocal investors, needs to be addressedquickly. There is a need to build informa-tion capacity which allows for more exten-sive, detailed and reliable economic andcapital market data that capture the diver-sity of Africa. In particular, there shouldbe a reliable database capturing the finan-

42

cial circumstances of private institutions,listed companies, and banks. The timeli-ness and reliability of financial data arecrucial for making reliable estimates ofinvestment risks in Africa. Thus, the deve-loping African financial systems require aresearch and information arm.

The financial system knowledge and data-base is one area for regional co-operationin terms of pooling resources. The activi-ties of existing institutions, such as theAfDB, the UN ECA, AERC, can be levera-ged for them to serve as an anchor for

the collaborative effort in setting up theresearch and information arms of bankingand stock market development in Africa.The added benefit of deep capital marketand banking databases in Africa is thatthey allow for first-rate research to beconducted by African financial economistsas well as others interested in Africa.Moreover, the database facilitates theestablishment of a frontier betweenAfrica’s index and regional indices moni-tored both by researchers and investorsaround the world.

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Figure 6: Regional Ratings: Sub-Saharan Africa versus Others

Building capacity to managecurrency risk

Depreciation and wide fluctuations in thevalues of African currencies can inducean important risk factor in the Africanstock market scene. High currencyexchange volatility is endemic to Africaneconomies, creating an impediment toforeign investments. There is evidencethat currency depreciation has an adver-se impact on the performance of Africanstock markets (Senbet and Otchere,2006). Unlike hard currencies, African

currencies are not readily hedged. Inview of the dearth of hedging mecha-nisms through derivative markets, anindirect approach would be to increasethe number of export-oriented companieson the stock exchanges, particularlythose with exposure to hard currencyexports should be targeted.

Macro-economic stability: standardstory but still important

Macro-economic and political instabilitieslead to volatility in the financial markets.

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Table 5: Country Ratings

AlgeriaBotswanaCote d'IvoireEgyptGhanaKenyaMalawiMauritiusMoroccoNamibiaNigeriaSouth AfricaSwazilandTanzaniaTunisiaUgandaZambiaZimbabweSub-Saharan AfricaEurope and Central AsiaMiddle East and North AfricaEast Asia and PacificLatin America and theCaribbeanWorld

22.849.818.535.129.627.919.750.839.3

15.246.3

45.516.116.532.521.127.23144

30.928.5

26.536.525.545.430.724.819.553.944.338

17.945.6

19.550.321.714.925.122.232.131.138.2

34.529.7

41.662.215.741.125.824.618.853.949.439.820.254.630.721.852.620.115.311

20.236.134.533.5

34.129.1

53.966.420.154.137.630.621.556.254.250.240

66.732.630.160.729.925.4

825.946.742.840.3

44.636.8

54.766.819.550.734.729.820.756.355.150.838.365.829.127.961.326.9275.824.449.555.330.8

43.446.6

53.467.521.352.136.332

19.854.854.249.640.964.828.829.261

30.627.77.625.150

56.731

44.947

54.0567.1520.451.435.530.920.2555.5554.6550.239.665.328.9528.5561.1528.7527.356.7

24.7549.75

5630.9

44.1546.8

Country/Region 1996 1999 2003 2007 Mar-08 Sep-08 2008

Source: Institutional Investors Credit Ratings.

The accumulating evidence is thatmacroeconomic stability, such as low andpredictable rates of inflation, fosters finan-cial development and helps stabilize thefinancial system.

Political risk is not just associated withpolitical turmoil. It often arises from thelack of quality institutions such as law andorder and democratic accountability,which then contribute to increased riskpremia in financial markets. Political riskis also associated with the odds of adver-se changes in government policies. Africais unfortunately filled with frequent casesof changes in government policies andpolitical climate. These abrupt changeshave adverse consequences on financialsystem development.

With regard to the stock markets, higheconomic and political instability can leadto severe information asymmetries in thestock market. This in turn induces excessvolatility in the market, serving as a bree-ding ground for noise traders and gam-blers. This would be destabilizing to thestock market as well as to the economy atlarge. As the markets cease to accuratelyreflect the fundamentals, speculativebubble is likely to emerge, which will thenburst into a crisis similar to what we arewitnessing today.

5.9 Policy reversals? Continuationof a market-based reform path

The damage from this crisis to Africa is sosevere that a temptation may exist both in

policy and popular circles to reverse acourse toward the old dysfunctional andcommand financial economy. The reversalof privatization of finance and of themomentum of integration into the globalfinancial economy should be resisted.Otherwise, this is another collateral dama-ge of the crisis, but this time, it is underthe control of Africans themselves.

The temptation for reversal is being fueledin part by the advanced countries in whichgovernment intervention has becomerampant in the crisis resolution. For ins-tance, the USA has been an ardentexporter of financial services and of itsphilosophy of market economy. In thepast, it often pushed for a market-basedapproach for the resolution of crises inemerging economies (e.g., the Asian cri-sis), but it now “part-nationalizes” its owninstitutions in the face of its own crisis.The presumption is that this is a tempora-ry measure in view of market failure, andthe government will promptly exit oncethings get reversed. We should hope so.

Interventionists around the globe arehaving a field day. African countriesshould not get caught up with that wave,and they should engage in policy res-ponses and reforms to get the regionback on a path of growth momentum andwell-functioning financial systems. A well-functioning market is like a soccer gamewith clearly defined rules of game and acompetent and well-behaved referee. If

45

unsupervised or poorly regulated, self-interested market participants will gamethe system and engage in excessive risk-taking. Self-regulation that is devoid ofgovernment participation is a myth andmisconception. Now more than ever,paradoxically, government intervention isneeded to save a market system, but thegovernment should exit fast.

To sum up, the genuine reforms thatAfrica has undertaken have empoweredprivate initiative, with considerablepayoffs. The global financial crisis shouldnot be an occasion to reverse course buta rare opportunity for Africa to undertakereforms that support, and even accelera-te, the momentum of the recent growthpath that should resume upon global eco-nomic recovery.

6. Concluding Note

This concluding note is an alert on twofeatures of the current crisis: financialregulation and financial globalization.Based on lessons of financial history,financial crises are endemic to financialsystems that are dynamic and innovative.The stark lesson from the current globalfinancial crisis is that finance needs regu-lation. But what is needed is not just moreregulation but good regulation. Movingforward regulatory reforms helps removeregulatory gaps, but they should not beexpected to eliminate financial crises inthe future. However, if these reforms pro-

duce good regulatory schemes, theyshould reduce the frequency and severityof future crises. The current crisis hasgiven us a rare opportunity to improve, oreven redesign, the financial and regulato-ry structure for the 21st century. Thispaper has attempted to make a contribu-tion to that effort.

Financial globalization is here to stay.African countries should not avoid globali-zation in the pursuit of a total preventionof financial risk potentially arising fromtheir integration into the global financialeconomy. Rise avoidance leads to lack ofaccess to the potential benefits of finan-cial globalization as detailed earlier.Moreover, with the crisis of such a globalmagnitude, those African countries whichshun financial globalization are not immu-ne but hurt through the real sector trans-mission of the crisis. Thus, the crucial les-son to be drawn from the current crisis isthat, as Africa ventures into global integra-tion, it should develop appropriate mea-sures to reform the financial system, parti-cularly building its capacity to manage risk(i.e., while the sun is still shining) andresolve the crisis efficiently if it arises.Without such measures and capacity, theregion would have difficulty in witheringthe discipline coming from the globalfinancial markets, which can be suddenand ruthless as witnessed by the ongoingglobal financial Tsunami.

46

47

ReferencesAllen, F., E. Carletti, R. Cull, J. Quian, L.W. Senbet, 2009, “The African Financial DevelopmentGap”, working paper.

Barth, J., G. Caprio Jr., and R. Levine, 2001, “Banking Systems Around the Globe: Do Regulationand Ownership Affect Performance and Stability?” in Mishkin, Frederic (ed.) PrudentialSupervision: What Works and What Doesn’t University of Chicago Press.

Clarke, G., R. Cull, and M. Shirley, 2004, “Empirical Studies of Bank Privatization: Some Lessons”,mimeo, World Bank

Cull, R., L. Senbet, and M. Sorge, 2005,“Deposit Insurance and Financial Development”, Journalof Money, Credit, and Banking. Vol. 37, pp. 43-82.

Gande, A., K. John, and L.W. Senbet, 2008, “Bank Incentives, Economic Specialization, andFinancial Crises in Emerging Economies”, Journal of International Money and Finance, Vol. 27(5),707-732.

Gande, A. and L. W. Senbet, 2009, “The Impact of Global Economic Crisis on Debt Sustainabilityof Low Income Countries”, UNCTAD draft paper.

Gompers, P., J.L, Ishii and A. Metrick, 2003, Corporate Governance and Equity Prices, QuarterlyJournal of Economics, Vol. 118, No. 1, pp. 107-155,

IMF Report,, 2009, “Impact of Global Financial Crisis on Sub-Saharan Africa”.

John, K., A. Saunders, and L. Senbet, 2000, “A Theory of Bank Regulation and ManagementCompensation (2000)”, Review of Financial Studies, Vol. 13, No.1, pp. 95-126.

Levine, R., and Zervos, 1998, Stock market development and long run growth, Policy ResearchWorking Paper, The World Bank.

Senbet, L.W., 2001, “Global Financial Crisis: Implications for Africa”, Journal of AfricanEconomies, Vol.10, February, pp. 104-140.

Senbet, L.W. and I. Otchere, 2006, “Financial Sector reforms in Africa: Perspectives on Issues andPolicies”, in Growth and integration ed Bourguignon F., and B. Pleskovic, Annual World BankConference on Development Economics.

Senbet, L. W., and I. Otchere, 2008, “African Stock Markets,” forthcoming the IMF volume “AfricanFinance in the 21st Century” (Blackwell Publishers).

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Recent Publications in the Series

N°

99

98

97

96

95

94

93

92

91

90

Year

2009

2009

2009

2009

2009

2008

2008

2007

2007

2007

Author(s)

Victor Murinde

Research Department

Abdul B. Kamara, AlbertMafusire, Vincent Castel,Marianne Kurzweil, DesireVencatachellum andLaureline Pla

Louis Kasekende, LeonceNdikumana and RajhiTaoufik

Margaret Chitiga,Tonia Kandiero andPhindile Ngwenya

Valérie Bérenger andAudrey Verdier-Chouchane

Research Division; AfDB

John C. Anyanwu andAndrew E. O. Erhijakpor

John C. Anyanwu andAndrew E. O. Erhijakpor

Tonia Kandiero

Title

Capital Flows and Capital Account Liberalisationin the Post-Financial-Crisis Era: Challenges,Opportunities and Policy Responses

Africa and the Global Economic Crisis: Strategiesfor Preserving the Foundations of Long-termGrowth

Soaring Food Prices and Africa’s Vulnerability andResponses: An Update

Impact of the Global Financial and EconomicCrisis on Africa

Agricultural Trade Policy Reform in South Africa

Des Inégalités de genre à l’indice de qualité devie des femmes

The Impact of High Oil Prices on AfricanEconomies

Education Expenditures and School Enrolment inAfrica: Illustrations from Nigeria and Other SANECountries

Health Expenditures and Health Outcomes inAfrica

Current Account Situation in South Africa: Issuesto Consider

ISBN - 978 - 9973 - 071 - 27 - 9