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Early Warning Systems and Banking Crises in Low Income Countries in Sub-Saharan Africa

May 20, 2013
The global financial crisis has stimulated renewed interest among academics and policymakers in early warning systems (EWSs) or models able to provide risk alerts on the potential for systemic banking crises on an objective and systematic basis. Most of the attention has been devoted to advanced economies, which have been at the epicentre of the recent turmoil. With the notable exception of the IMF, which has recently initiated a research program aimed at enhancing its financial sector surveillance framework, low income countries (LICs), particularly in Sub-Saharan Africa (SSA), have not been explored as of late.
SSA LICs’ banking systems have on average proved resilient to the recent episodes of global financial stress. This is primarily the result of the structural reforms implemented by many countries over the past decade within a context of sound macroeconomic policies. Most countries have improved the regulatory framework for supervision, bolstering prudential requirements and supervisory rules. However, as banking systems deepen and new sources of risks materialise SSA LICs need to move ahead with their plans to strengthen supervisory capacity and financials sector resilience. Further actions are warranted to explore the impact of macroeconomic and financial developments on systemic banking risk. In this respect, EWSs can represent a valuable tool for policymakers and regulators in the region.
In a forthcoming paper co-authored with Giovanni Caggiano (University of Padua) and Leone Leonida (Queen Mary University of London) we develop an EWS of new generation to predict systemic banking crises in SSA LICs. In particular, we focus on a sample of 38 countries during 1980-2008. Focusing on a group of homogenous economies contributes to improve the predictive power of EWSs. Moreover, despite having experienced a number of systemic distress episodes, especially during the 80s and 90s, SSA LICs have received no attention in the relevant empirical literature. We test for a number of macroeconomic and financial variables that have been widely used in the literature as well as for indicators proxying the structural characteristics of SSA LICs’ banking systems.
We find that a decline in real output, a depreciation of the nominal exchange rate, high domestic credit growth, and banking system illiquidity are all positively correlated with the probability of incurring a systemic banking crisis in SSA LICs. Our findings indicate that banking distress in SSA LICs is typically preceded by weakening macroeconomic fundamentals, in particular a slowdown in economic activity and a depreciation of the currency. Given the low economic diversification of SSA LICs, any decline in GDP growth is felt by the banking sector through a generalised deterioration in asset quality, which increases the probability of a systemic banking crisis, other things being equal.
On the other hand, a depreciation of the exchange rate lends credence to the hypothesis that banking crises in SSA LICs may be driven by excessive foreign exchange (FX) risk exposure. Our results show that currency turmoil can indeed trigger a banking crisis when banks are highly exposed to FX risk. This can affect the banking system directly, through currency mismatches in the balance sheet, or indirectly, through exposures to unhedged borrowers. Moreover, the high dollarization of most SSA LICs exposes them to the risk of a generalized run on their foreign currency deposits. Given that our proxies for currency mismatch in the banking system’s balance sheet (net open FX position) and for liability dollarization (M2 to reserves) are not statistically significant, we can infer that the channel through which a currency depreciation works in SSA LICs is primarily indirect, i.e. via exposures to FX risk by bank borrowers.
Our results also show that rapid domestic credit expansion relative to GDP precedes banking crises. This may signal the peak of a credit cycle, where relaxed credit standards and build-up of financial imbalances in the real economy lead to widespread defaults and therefore systemic banking problems. Related to this, we find that the banking system in SSA LICs is crisis-prone if it engages in excessive credit activity relative to the deposit base. In other words, the probability of a systemic banking crisis increases when banks tend to finance an increasing share of their loan portfolio with non-core liabilities, resulting in low liquidity and/or vulnerability to deposit withdrawals.
Our results have important policy implications at a time when financial regulators and central banks in SSA LICs are reassessing their financial regulatory agenda in the context of recent reforms spurred by the global financial crisis, in particular Basel III. Our findings underline the need to implement an effective macroprudential framework in addition to standard microprudential regulation, monetary policy and administrative measures to address the risks to financial stability emanating from undiversified and dollarized environments. In this respect, SSA LICs’ financial systems might benefit from credit-related measures such as sectoral ceilings on credit exposures and/or credit growth, and higher risk weights and/or provisioning rates on foreign currency lending to ensure adequate protection from concentration risk and currency-induced credit risk.
In terms of microprudential regulation, implementing the liquidity requirements set out in Basel III might also be a useful complement to existing liquidity rules. On the other hand, our results do not warrant tightened capital requirements, which represent the cornerstone of recent international regulatory reforms. Finally, it is important that financial regulators in the region, with the assistance of international financial institutions, continue efforts to strengthen supervisory capacity, especially in contexts of sustained credit growth, as was the case in Nigeria before the 2009 banking crisis . Ultimately, EWSs are useful tools for policymaking but should never substitute the judgment of financial regulators.
Pietro Calice is Principal Investment Officer with the African Development Bank

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