Financial market fragmentation and reforms in Sub-Saharan Africa

Abstract

What explains the existence of fragmentation in African financial markets and its persistence despite reforms to liberalize those markets? This paper reports findings from surveys of formal and informal institutions and their clients in Ghana, Malawi, Nigeria and Tanzania to test hypotheses explaining different aspects of fragmentation - which occurs when different market segments are poorly linked and interest rate differentials cannot be fully explained by differences in costs and risks. A central hypothesis was that reforming financially repressive policies would not be sufficient to overcome fragmentation of financial markets because of structural and institutional barriers to interactions across different market segments. Substantial fragmentation of financial markets was observed. Informal and formal lenders largely pre-selected their client groups according to the availability of information and ability to manage risk using a specific methodology and product. The relatively low transaction costs and loan losses of informal institutions indicated that they provided a reasonably efficient solution to information, transaction cost and enforcement problems that exclude their clients from access to banking services. Nevertheless, the high rates of some moneylenders implied substantial monopoly power in underserved markets. The findings showed little short-term impact of financial liberalization on financial deepening, liability structures, product innovation and outreach of formal banking systems, despite some strengthening of portfolios, competition and supervision. The continued lack of interest of banks in smaller clients can be explained by their collateral-based methodologies, perceptions of high risks, the costs of small transactions, and incentives for lending to the public sector. Increased competition in banking has generally not been sufficient to overcome these obstacles and stimulate banks to aggressively seek new, smaller clients. The findings imply that financial liberalization and bank restructuring in the African context should be accompanied by complementary measures to address institutional and structural problems such as contract enforcement and information availability. Despite liberalization of financially repressive policies, the assets of informal lenders and savings collectors increased because of their linkages with expanding real sectors (for example, moneylenders are often traders with excess short-term liquidity), despite lack of access to formal finance. But the high localization of informal agents limits the extent of their financial intermediation. The study identified financial gaps representing demand for credit by viable small enterprises that cannot satisfy the information and collateral requirements of banks but that demand larger or longer-term loans than informal lenders can provide. In some countries, innovative semi-formal institutions - non-banks registered as business enterprises - were emerging in response to such gaps. These range from questionable pyramid-type schemes to near-banks using modern banking methods to serve informal clients. The study concludes that financial development strategies, and World Bank operations supporting them, should explicitly include informal and semi-formal financial institutions and attempt to reduce structural impediments to integration of different market segments in order to improve the extent and efficiency of financial intermediation in the medium term. 'Integration' means greater interaction between (and within) segments and access of clients to them, allowing different types of institutions to specialize efficiently for different segments. Banking laws and regulations in Africa need to be differentiated to take account of the different methodologies and susceptibility to regulation of different tiers of the financial system - formal, semi-formal, and informal. � 2013 Elsevier B.V., All rights reserved.