Ongoing challenges to African banks and the effectiveness of regulatory responses to the covid-19 crisis

This article is extracted from the MFW4A Covid-19 Report.

The African banking sector has, in the recent past, recorded some impressive transformation. Three major factors set the year 2020 to be the springboard for growth across sectors: the first was the growth of Pan-African banking groups; the second was the consolidation of individual banks within various jurisdictions to create larger entities; and the third was the anticipated resilience in economic growth projected for most African economies.

However, the outbreak of the Covid-19 pandemic was a convulsive shock to the global economy. Furthermore, the intensity and duration of the pandemic, the means and speed of economic recovery, and the structural changes it will bring in the longer term, remain unclear.

According to the IMF’s World Economic Outlook for January 2021, the pandemic is expected to significantly worsen the economic outlook for Sub-Saharan Africa (SSA), with economic growth projected to fall to -2.6% in 2020 before recovering to 3.2% in 2021. The lockdowns and restriction of people’s movement to mitigate the spread of the pandemic have jeopardized the livelihoods of millions of already vulnerable groups. The disruption to supply chains and sharp reductions in demand have undoubtedly exerted pressures on low- and middle-income consumers. As a result, close to 25 million Africans are expected to fall below the extreme poverty line, thus erasing five years of progress in poverty reduction.

What does this mean for the regulation of Africa’s banking system?

Regulation of the banking system in Africa has improved over the last decade, particularly with the implementation of the Basel II and Basel III regulatory frameworks for banks. To boost the resilience of the sector against financial and economic shocks, regulators across the continent have emphasized the strengthening of the capital base of financial institutions and the implementation of sound liquidity risk management systems.

However, the pandemic poses a significant risk to the stability of Africa’s banking sector. Non-performing loans are likely to increase following a decline in economic activities because of borrowers’ inability to meet their obligations. Individual institutions also remain vulnerable to failure. For example, microfinance institutions (MFIs) that cater for households, and
Micro and Small to Medium Enterprises (MSME) in the informal sector, particularly those with high concentrations in sectors affected by the Covid-19 shock, will come under stress and risk of insolvency because of the erosion of household incomes.

What has been the policy response to the Covid-19 pandemic so far? Regulators of the banking sectors took immediate steps to manage potential financial instability. They did this by lowering bank cash reserve ratios to increase liquidity in the banking system and encourage lending, implementing credit relief measures to cater for potential deterioration in borrowers’ ability to meet their obligations, releasing capital and liquidity buffers, and reducing capital ratios. Additional measures included temporarily limiting capital distribution by restricting payment of dividends and bonuses. Central Banks in countries like Ghana, Lesotho, Nigeria, Rwanda, The Gambia and Zimbabwe explicitly lowered their policy rates, as well as introducing several policy options to improve overall liquidity and discipline in the banking system.
Despite efforts by policy-makers to increase liquidity and provide credit relief for borrowers, the downcast economic outlook is likely to heighten banks’ risk-averse behaviour and adverse selection, with reductions in new lending and capital flight to safer assets such as government securities. Indeed, such actions could add to existing recessionary forces in SSA.
Moreover, not all MFIs’ customers are currently benefiting from these credit relief measures. While several African governments provided stimulus packages to businesses badly hit by the pandemic, the size of those packages and the number of beneficiary SMEs have been lower than expected.

Ongoing challenges for banks in Africa

The banking sector was expected to play a crucial role in mitigating the unprecedented macroeconomic and financial shocks caused by the pandemic, notably by maintaining the critical financial services needed to support economic recovery while mitigating financial risks. However, several challenges inhibited banks’ attempts to maintain resilience and promote early recovery. The main challenges are discussed below:

1. Maintaining bank resilience

The banks’ main concern is the potential increase in the credit risk of borrowers stemming from the downturn in economic activity. Higher moral hazards resulting from information asymmetry between banks and borrowers may significantly increase the already high credit risk. Such moral hazards pose a significant challenge to the overall banking sector, especially because information-sharing offices are new to Africa, with limited data on borrowers. In order to mitigate this risk and to enable borrowers to weather the storm, the majority of banks, with support from regulators, have implemented credit relief measures to provide a window within which borrowers can delay repayment of their obligations until their incomes are stabilized or new credit is provided.

i. Banks in Africa typically have high cost-to-income ratios, averaging 59.05% in 2017, according to data from Bankscope. The bulk of these costs are associated with the operation of traditional brick and mortar branches, which were already shedding prior to the pandemic, through increased digital banking and adoption of agent banking. However, cost optimization continues to pose significant challenges to banks’ efficiency.
ii. There has been a surge in the adoption of remote services by bank customers, who are taking advantage of digital channels to meet their banking needs. In order to stay relevant and capitalize on changes in consumer preferences, banks will have to pay closer attention to customer experiences and adjust their products and services accordingly. This will pose significant challenge for banks that are not agile enough to respond to this evolving digital space in the banking sector.
iii. The shift towards the adoption of alternative banking channels also brings to the fore the challenge of competition from non-bank entities, such as telecoms and fintechs operating in this space. To remain competitive, banks will have to innovate by adopting mobile finance and integrating it seamlessly into their operations.
iv. The issue of cybersecurity also reflects the shift in customer behaviour, as well as cost optimization, which calls for increased operational resilience. Cyber security protocols have to be enhanced to address increased risks associated with remote working as staff are redeployed and customers are increasingly using digital channels following the closure of many bank branches. For branches still operating, there is limited physical contact between customers and banks staff as a result of the social distancing protocols.
v. Business continuity planning for the Covid-19 pandemic presents unique challenges to financial institutions because of the uncertainties surrounding the scale, duration and trajectory of the pandemic. Nonetheless, financial institutions need to prioritize their programmes, while employing sequential processes, to ensure the continuity of critical services and the health and safety of employees.

2. Overcoming challenges to recovery

i. To accelerate recovery, banks will need to re-assess their appetite for credit risk, taking into account the impact on sectors hardest hit by the pandemic. Here again, a tradeoff between recovery and support to the real sector will have to be made.
ii. Furthermore, to regain pre-crisis profitability, banks will have to further streamline their operating models. Collaboration to unlock cost savings in shared/shareable services such as ATMs, agents, points of sale and even cash handling will be critical. Redeployment of the workforce, re-skilling initiatives to take advantage of digitalization, and the adoption of more flexible work arrangements are other cost optimization opportunities. The automation of routine, low-cost processes and redeploying their workforce to more technical and intellectual tasks will help banks increase productivity and enhance risk management.
iii. Banks’ credit cycles have typically been long and onerous, with borrowers having to wait for long periods to access funding. This may exacerbate an already difficult situation. Banks will therefore need to explore avenues of reducing the “queueing period” by automating and digitalizing their services.
iv. To further entrench their customer value proposition, banks need to provide crisis-related products and services to their customers and unlock new client segments. Income smoothing products such as overdrafts, cashflow forecasting assistance to borrowers and the introduction of SME payment platforms, as well as products targeting the financial needs of MSMEs and vulnerable gender groups, are some of the areas that can be tapped for recovery and growth.

3. Re-engineering and repurposing of banking process

i. Going forward, banks will need to strengthen credit risk assessment processes to ascertain the resilience of borrowers throughout the Covid-19 crisis. Early warning systems designed to detect changes in the risk characteristics of borrowers will have to be recalibrated to distinguish between short- and long-term changes in credits worthiness.
ii. The drive towards digital transformation cannot be overlooked by banks aiming to thrive in the new economy. Collaborating with financial technology (fintech) companies, leveraging on the fast-growing payments space and adjusting operating models to adapt to a technology enabled business environment are some of the potential avenues for growth.
iii. The use of big data, artificial intelligence and machine learning for customer behaviour analyses, such as generating credit scores, will be part of the way forward.

The effectiveness of banking regulatory responses to Covid-19 Pandemic

Given the unprecedented nature of the Covid-19 crisis, banking regulators and supervisors face considerable challenges in maintaining financial stability, preserving well-functioning core markets and ensuring the flow of credit to the real economy. It is important for regulators to ensure that the adopted policy responses minimize opportunities for moral hazard and maintain adherence to sound credit risk management practices while facilitating the efficient allocation of new credit. In their joint recommendations to national supervisors, the IMF and World Bank encouraged a balance between these two policy objectives. The recommendations call for: adherence to internationally-agreed minimum regulatory standards and supervisory principles and guidance to the banking sector on asset classification; provisioning for, and maintenance of, transparency; the suspension of automatic triggers of corrective supervisory action; and coordination with domestic and international supervisory authorities.

How do these recommendations aid in promoting financial stability?

By encouraging flexibility in the supervisory framework while upholding minimum standards, the vital signs of the banking system are consistently maintained and monitored to minimize the emergence of attendant risks that would exacerbate the already fragile economic state. 
Guidance on asset classification is intended to facilitate the identification of credit impaired assets on bank balance
sheets, by allowing banks the flexibility to make case-by-case assessments of the likelihood of repayment. It is not intended to prevent banks from classifying any such loans as impaired on a blanket basis.

Transparency is intended to facilitate coherent and consistent monitoring of the effects of the crisis on banks. Collaboration between supervisory authorities is an important avenue for resolving conflicts arising from differences in the supervisors’ objectives. For example, while macro prudential authorities may allow the release of capital buffers, micro prudential authorities may wish to take a more cautious approach to regulatory capital, in light of the heightened risks to the banking system.

Data availability and collection will be critical in enabling financial sector regulators to monitor and assess the key risks that may be crystallizing in the financial sector as the pandemic unfolds. The data will facilitate the timely formulation of policies to address such risks. The data will also inform policy decisions related to the unwinding of restrictions and regulatory forbearance introduced by regulators to promote capital preservation in financial institutions.

On the monetary and fiscal front, government policy responses should be centred around reduction in the Central Bank policy rate, liquidity support to financial institutions, tax holidays, and the allocation of funds to support key sectors such as health.

The effectiveness of fiscal and monetary policy

Beyond these, a number of other challenges remain and need to be addressed. On monetary policy formulation that largely relies on modelling of various economic conditions, the uncertainty surrounding the evolution of these conditions during the pandemic provides significant statistical challenges for economic modelling. The other uncertainty relates to the transmission mechanism to the real sector, given the potential risk averse behaviour in the banking sector. Consequently, policy-makers will need to exercise judicious expert judgment, focusing on a short-term horizon, in the formulation of monetary policy until the crisis ends.

On the fiscal front, the pandemic has put additional pressures on the already widening fiscal deficits of various African
economies, which are largely financed by domestic debt that may require strong fiscal consolidation to unwind. Given their constrained fiscal space, African countries need to focus on the sustainability of their fiscal policy, giving special attention to improving revenues and re-aligning overall expenditure in favour of priority areas.

Banks and banking regulators and supervisors need to consider the risks emerging from the “new normal”, and thus adopt forward looking approaches to risk management. Regulators should consider how Covid-19 has transformed the market landscape and business models of supervised institutions, and adopt supervisory frameworks to keep pace with these developments.

Despite the ongoing challenges and uncertainties resulting from the Covid-19 pandemic, the resilience of the banking sector will be key to ensuring the recovery and sustained growth of African economies.