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Sudan: Staff Report for the 2013 Article IV Consultation—Financial Sector Review

Author(s):
International Monetary Fund. Middle East and Central Asia Dept.
Published Date:
November 2013
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Background: Secession of South Sudan, a Structural Break

1. While the direct impact of the secession of South Sudan on July 9, 2011 on the economy was significant, the impact on the financial system was more modest, reflecting the concentration of the financial system in Khartoum. The secession resulted in a large fiscal shock, with Sudan losing some three-quarters of its oil production—half of its fiscal revenues—and a balance of payment squeeze, with about two-thirds of its international payment capacity vanishing overnight. This has weakened macroeconomic fundamentals. The stock of bank credit to the private sector decline by 7 percent (0.9 of GDP) during the secession, corresponding to the amount of credit outstanding provided by the southern branches of Sudanese banks. Nonetheless, the indirect impact over time on financial sector growth is likely to be significant. Oil revenues, which would in the past have transmitted through the Sudanese banking system will increasingly be channeled through neighboring countries such as Kenya.

2. Monetization and financial intermediation is weak. Broad money is only 26.3 percent of GDP, compared to 48 percent on average for LICs, and the share of currency in broad money is high. Deposits are also low at only 19 percent of GDP. As a result, domestic credit to the private sector is also low at only 12.1 percent of GDP versus the 32.6 percent LIC average at end-2012 (Figures 1 and 2).

Figure 1.Domestic Credit to the Private Sector

(Percent of GDP)

Sources: Sudanese authorities; and IMF staff calculations.

Figure 2.Sudan: Financial Depth

Sudan’s Financial System Structure

3. Sudan’s financial system, as in many other low-income countries (LICs), is dominated by the banking sector (Table 1). Insurance companies account for virtually all of the remainder although there is a small but growing microfinance sector.

Table 1.Structure of the Sudanese Financial(End-2012)
Assets
NumberSudanese Poun (millions)ds Percent of Assets
Banks
Government-owned49,07513%
Joint venture2552,32477%
Foreign-owned65,6508%
Insurers
Othersn/a966 (2011)1%
Source: Central Bank of Sudan.
Source: Central Bank of Sudan.

4. There is essentially no interbank market largely, due to the persistent excess liquidity in the system, lack of trust among banks, and the ease with which liquidity can be obtained from the CBOS. More importantly, under purely Islamic systems, such as Sudan’s, there are no short term liquidity products that comply with Shariah rules and principles. However, there is an informal inter-bank market (Qard Hassan) in which banks lend to each other without charging any fee or expecting any profit for short periods such as one week. This is done on a favor trading basis.

5. The absence of an active interbank market and a cap on commercial bank holding of government and central bank securities have led to exceptionally large excess reserves (Figure 3) and a loss of monetary control with the CBOS providing direct credit to government (Figure 4) and to individual banks while lacking the means to mop up the resulting excess liquidity. Banks can only invest up to 20 percent (25 percent prior to 2013) of their investable funds in government securities, short-term Murabaha investments, and central bank certificates (Box l).1 As in other Islamic banking systems, the lack of adequate monetary instruments has led to high intermediation cost and persistent inflationary pressures (Figure 5).2

Figure 3.Sudan: Commercial Banks’ Reserves

Source: Sundanese authorities and staff estimates.

Figure 4.Sudan: Composition of Credit to Central Government

(Percent of total credit to government)

Source: IMF International Financial Statistics.

Figure 5.Sudan Consumer Price Inflation

(Annual percentage change)

Source: IMF International Financial Statistics.

Box 1.Securities Subject to the 20 Percent Holding Ceiling

Banks may hold up to 20 percent (25 percent until end-2012) of their financing portfolio in Government Musharaka Certificates (GMCs), Government Investment Certificates (GICs), CBOS Ijarah Certificates (CICs), Khartoum Petroleum Refinery Certificates, and other Sukuk.

GMCs, also known as Shahama, are issued in registered form by the Ministry of Finance (MOF) through auctions. They are based on Musharaka with a one year renewable maturity at the government’s option. The nominal value of each certificate is SDG 500 and their profits are distributed annually. The return on GMCs is based on the return from underlying projects and capital gains derived from revaluations of project assets. These are the highest yielding certificates.

GICs known as Sarh/Sukuk and issued in registered form by the MOF are used to finance development projects. They are based on a pool of Islamic financial instruments such as Mudarabah and Ijara with nonrenewable maturities ranging from two to six years (typically five). Investors get a share of the profits generated by the underlying projects. The nominal value of each certificate is SDG 100 and their profits are distributed quarterly and semi-annually. There are also GICs known as Shama backed by the assets of the Petroleum Refinery of Khartoum. The yield is fixed and is paid on a quarterly basis. Central Bank Ijara Certificates (CICs) known as Shehab are issued only to banks by the CBOS with a 10 year-maturity and a fixed annual return of 12 percent paid monthly. CICs are backed by the CBOS building and are issued by the SFSC. These are mainly used by the CBOS for open market operations, and purely for monetary policy purposes. Dealing in these certificates is restricted among the banks and the CBOS. The nominal value of each certificate is SDG 1,000.

A. Banking Sector

6. The banking sector is composed of 35 banks, 4 of which are CBOS/government-owned, 25 are jointly CBOS/government- and privately-owned, and 6 are foreign-owned (Table l).3 The government-owned banks include three specialized financial institutions (SFIs) jointly owned by the CBOS and Ministry of Finance, and mandated to fill specific access-to-finance gaps.4 In all, 90 percent of banking system assets are those of banks owned fully or jointly by the CBOS and/or government. Given the CBOS’s supervisory role, this presents obvious conflicts of interest.

7. That the Sudanese banking system is largely Islamic has implications for financial stability. While conventional intermediation is largely debt based and allows for risk transfer, Islamic intermediation, in contrast, is asset based and centers on risk sharing, thereby being a better shock-absorber. Depositors share the risk and return in Islamic banks, with no guaranteed return. Resilience is therefore achieved, as leverage through debt is not permitted, and derivatives are typically prohibited, though other sources of risks, such as liquidity risks, may indeed be higher than in conventional banks. Islamic banks also lack the instruments for managing risks—such as derivatives—and hedge against risks that conventional banks have.

8. The banking system is weaker than its sub-Sahara African peers. Return on assets and equity have gradually recovered since the lows reached in 2008, although it is still well below the inflation rate (Table 2, Figures 5 and 6). Capital asset ratios, moreover, are generally below the required 12 percent—reflecting a lack of compliance—nonperforming loans (NPLs) are high but provisioning is low—suggesting potentially weak buffers—although they have recently been improving (Figures 7 to 11). However, Sudanese banks are required to denote loans as nonperforming when they are more than one month overdue for all Murahaba mode assets, which comprise the majority of bank loans. The NPL threshold for other loans is three months. The international standards generally use a three-month threshold.5

Table 2.Recent Rates of Return on Sudanese Bank Assets and Liabilities(In percent)
Bank AssetsBank Liabilities
Murabaha & Musharakah110-12Deposits0
GMCs and GICs16-18Investment accounts7-9

Out of SDG 24.1 billion of total funding flows in 2012 SDG 12 billion were Murabaha and SDG 2.6 billion were Musharakah.

Out of SDG 24.1 billion of total funding flows in 2012 SDG 12 billion were Murabaha and SDG 2.6 billion were Musharakah.

Figure 6.Sudan Return on Equity Asset

Source: Central Bank of Somalia

Figure 7.Bank Regulatory Capital to Risk-Weighted Assets

(End-2012, in percent)

Sources: National authorities; and IMF staff calculations.

Figure 8.Nonperforming Loans to Total Loans

Sources: National authorities; and IMF staff calculations.

Figure 9.Loan Loss Provisions to Nonperforming Loans

(End-2012, percent)

Sources: National authorities; and IMF staff calculations.

Figure 10.Gross Nonperforming Loans to Gross Loans

(In percent)

Sources: Sudanese authorities; and IMF staff calculations.

Figure 11.Bank Regulatory Capital to Risk-Weighted Assets

(In percent)

Sources: Sudanese authorities; and IMF staff calculations.

9. Although a recent reorganization of the onsite inspection teams was helpful (see Box 2), more effort is needed to build their capacity, develop a consistent inspection methodology and build a better and a more risk-based inspection plan. In addition, the coordination and exchange of information between the onsite and offsite functions need many enhancements to develop a complete and comprehensive assessment of banks and to achieve more effective supervision. It is worth noting that new functions have been added to the banking supervision department to improve the coordination between Prudential Supervision and the Inspection Directorates.

Box 2.Banking Supervision Structure

The Banking Supervision Department at the CBOS consists of the Prudential Supervision Directorate (PSD) and the Inspection Directorate (ID). The PSD is responsible for the regular offsite analysis of banks and financial companies, while the ID is in charge of the onsite assessment. The PSD is in charge of monitoring the financial performance of banks, financial companies, and the financial sector based on the analysis of their main prudential indicators and according to their “Capital, Assets’ Quality, Earnings, and Liquidity” (CAEL). The PSD assigns CAEL ratings to the banks according to specific benchmarks.

The ID used to consist of ten teams, each responsible for inspection of a specific theme at the banks (e.g., corporate governance, financial statements, etc.). Because of this purely theme-based methodology, the ID did not possess a comprehensive assessment of banks’ financial and managerial performance. During the first half of 2013, the inspection teams were restructured in order to be responsible for banks rather than specific themes. There are now eight 6-7 person teams, of which six are responsible for a number of banks, one is responsible for inspection of the payments systems, and the other is responsible for non-bank financial companies. This restructuring will provide better and more comprehensive onsite assessments.

10. Despite banks being restricted in lending to the sovereign, little lending takes place to the private sector. After a rapid increase in credit to both the government and non-government sectors in 2001-06, credit to non-government has been stagnant (as a percent of GDP; Figure 12). A number of obstacles, which are typical of LICs has contributed to this, including:

  • Informational asymmetries. Lack of information on borrowers, including due to the limited size of the formal sector and the limited availability of audited company statements increases adverse selection and moral hazard issues, and ultimately leads to credit rationing. Information asymmetries are also an issue for the development of the interbank market. However, under Islamic banking, this problem is in part dealt with as the incentives of investors and entrepreneurs are aligned, given the risk-based sharing arrangement.
  • Business and judicial environment. A key issue is the absence of formalized property rights in large parts of the country, which increases the difficulty of using land as collateral in lending. Moreover, the judicial process tends to be costly and slow. This inability to recoup losses at a reasonable cost, through collateral initially pledged, discourages lending further.
  • Skills. The quality of human capital is critical for banks as it provides the necessary risk management expertise and the ability to design and sell the products that customers need. The lack of appropriate skills may explain why in recent years some MFIs that moved from dealing with micro-enterprises to dealing with SMEs saw their profitability decrease. Banks may face similar challenges moving from larger enterprises to SMEs.

Figure 12.Sudan: Commercial and Central Bank Credit to the Central Government and Non-Government Sectors

Financial Infrastructure

11. An important recent development has been the enhancement of the credit registry operated by the CBOS. The registry was formed in 1996 but it was not until 2006 that banks had online access to the data. Since June 2008, the IMF has been providing technical assistance (TA) to upgrade the registry to best practice, and in 2012 the Credit Information and Scoring Agency (CIASA) was established as a separate agency within the CBOS.6 More recently, newly installed software coupled with expanded data collection, will provide more accurate information on borrower performance and will allow more informed credit granting decisions. The enhanced registry will also allow the CBOS to more accurately and timely monitor credit risk in the banking sector and credit concentration at the level of banks as well as the banking sector as a whole.7

12. Substantial efforts have been made to complete the credit registry expansion project, but work is still needed to achieve a more effective coordination between the CIASA and various CBOS departments. This coordination has started, namely in producing and exchanging information about delinquent borrowers and clients banned from accessing financial services due to malpractices or irregularities. Coordination is also needed to ensure that the data submitted to the CIASA are accurate and complete. In this context, an inspection checklist prepared by CIASA is currently being used by the ID to verify the accuracy of the data sent by banks to CIASA in the course of the regular inspection performed over banks.

Deposit Insurance

13. All domestic currency bank deposits (current, savings and investment) are covered by the government-owned Bank Deposit Security Fund (BDSF) up to SDG 10,000 per depositor.8 Coverage is mandatory for all banks and the annual premia are 0.003 percent of total deposits.9 Accumulated premia (SDG 494 million at end-2012) now amount to about two percent of deposits versus a target of five percent. Local currency deposits totaled SDG 28.2 billion at end-2012. They have had to cover two failures since inception (in 1998 and 2000). The BDSF also stands ready to provide resources to solvent banks facing short-term liquidity problems. This “remedial role” is reserved for central banks in other countries.

B. Insurance Sector

14. The insurance sector in Sudan is small, even compared to those in other African countries. According to Swiss Re, total 2012 premium revenue was about 0.4 percent of GDP, versus 3.7 percent in Africa as a whole, and 6.3 percent globally. However, Sudan’s low level of insurance penetration is not unusual for LICs.

15. The primary business line for insurance companies in Sudan is vehicle insurance (40 percent of gross premia in 2011), which is not an extraordinary phenomenon observed in developing markets, and vehicle third liability insurance is compulsory in Sudan. Life insurance comprises only five percent of gross premia (Figure 13).

Figure 13.Gross Insurance Premia

(2011, in Sudanese Pounds)

Sources: Sudanese authorities; and IMF staff calculations.

16. All Sudanese insurance companies must operate in accordance with Islamic Sharia principles. Sharia requires insurance to be a “donation contract,” whereby policyholders donate the premiums to a common pool of resources, and claim payouts are considered a form of charity. Since policyholders are donors, no gambling is deemed to have occurred. Any surplus may be set aside as reserves or distributed to policyholders in proportion to the contributions paid.10

17. Insurers must maintain separate accounts for each policyholder to track all contributions. Administrative charges and costs of claims are allocated in proportion to contributions. Any surplus (after making provisions for pay-outs, operating costs, depreciation, bad debts and establishment of reserves) is allocated to policyholders in proportion to contributions paid, or set aside as reserves and investments on behalf of the policyholders.11

18. The 2011 World Bank Financial Sector Review concluded that there were shortfalls in the Sudanese insurance regulatory and supervisory framework.12 However, it is beyond the scope of this paper to update this analysis.

C. Microfinance Sector

19. The microfinance (MF) sector is small but growing rapidly, thanks to the authorities’ active promotion. The sector has come alive with the creation of a microfinance unit at the CBOS in 2007 and the establishment of the Sudanese Microfinance Development Facility (SMDF) in 2008. The SMDF has $20 million of capital, and is jointly owned by the CBOS and the Ministry of Finance and National Economy, and financed by donors (through a trust fund administered by the World Bank).13 These developments are the result of a plan, established in 2006, aimed at positioning the MF sector within a wider framework for poverty alleviation and economic and financial development14 As one part of this plan, the CBOS includes MF as a priority sector, and encourages banks to allocate at least 12 percent of their investable funds to the sector. Also two government-owned banks have been reorganized to focus on MF financing.15

20. The results of this push have been impressive to date. The number of MF borrowers went from 49,000 at end-2007 to 494,000 by 2012. The growth has occurred in both bank portfolios (49,000 to 300,000) and at the dedicated MF institutions (zero to 194,000). The CBOS MF Unit (MFU) estimates that the proportion of the adult population receiving MF funding from banks and MF institutions has gone from 0.7 percent to 8.2 percent over the same period. And returns are estimated to be competitive with those on Government Musharaka Certificates (GMC; see below) at about 18 percent. Moreover, NPLs on MF loans are much lower than those of commercial bank loans, although microinsurance, paid for by the borrower, plays a role in keeping them low.16

21. The banks are making slow but steady progress towards meeting the 12 percent of investable funds target for MF lending set by the CBOS. It was one percent in 2007 and about five percent at end-2012. But MF institutions, of which 18 are currently in operation (versus zero in 2007) and are regulated and supervised by the CBOS and MFU, may be the best suited to be the main drivers of future growth of this sector, even though banks are expected to continue to track towards the 12 percent target. This is to be accomplished mostly through the newly established Wholesale Guarantee Agency which would partially guarantee finance from banks to MF institutions. This will help reduce the CBOS’s participation in the MF wholesale funding market. In fact, the CBOS’s share of MF institution wholesale funding has already declined - during the 2007-12 period the CBOS provided about 60 percent of such funding, but it now stands at only about 37 percent of outstandings.

22. In other countries with active MF sectors, trade unions play an active role in funding and setting up MF institutions. Although the MF regulatory framework in Sudan allows unions to establish MF institutions, so far there are only two that have.17 However, Sudanese trade unions have social programs that provide cash support to members, which would make their involvement in the MF sector a natural fit. Also, the 2013-2017 Comprehensive MF National Strategy calls for a review of the cooperatives regulations with the intent of increasing the involvement of cooperatives in the MF sector.

23. In terms of active clients, Sudan and Bangladesh are easily the global leaders in Islamic finance microfinance, with Sudan likely to take top spot given current growth rates. Nonetheless, this is still a very small market- about $1 billion outstanding according to AlHuda Centre of Islamic Banking and Economics. Murabaha(cost plus mark-up) funding is the MF vehicle of choice in Sudan, as it is in other Islamic MF markets.

24. Finally, while high GMC indicative returns look like they could draw potential wholesale funds away from the MF sector, private-sector MF institution investors are looking to establish solid institutions for future higher returns. Also, some look at these investments as serving their communities and social obligations. Nevertheless, reductions in GMC issuance and/or returns could only be a good thing for the MF sector.

D. Equity Market

25. The Khartoum Stock Exchange (KSE) provides an organized market for the trading of equity shares, government certificates, and mutual funds backed by certificates or equities. However, the market is small and equity trading is thin, with weak corporate governance, poor regulation, lack of corporate transparency, and low awareness by the public hindering its development18 Plus, government securities dominate trading, and what little equity trading that occurs is dominated by one firm (Sudatel).19

26. Although the KSE switched from manual to computer-based trading in January 2012, trading still occurs for only one hour (10:00 am to 11:00 am) and brokers must be physically present at the exchange.

27. The KSE was established as a self-regulating government-owned institution controlled by a board of directors (appointed by the Council of Ministers). However, no amendments have been made to the original KSE law since 1994 in spite of the modernization of global financial systems, and developments in corporate governance around the world.20 The 2005 FSAP pressed the need to establish a legislative and regulatory framework for the securities market, and institutions to implement it, based on the IOSCO Objectives and Principles for Securities Regulation.21

28. Also, the World Bank 2011 Financial Sector Review made a number of recommendations with respect to upgrading the KSE’s regulatory framework. They called for the establishment of an independent market regulator to (i) supervise the market, and (ii) review and enforce rules on listing, disclosure and market operations. They also recommended establishing links with international regulatory bodies such as International Organization of Securities Commissions (IOSCO), for credibility and to improve investor appeal of the market.

Access to Financial Services Challenges

29. Challenges confront individuals and business enterprises in accessing financial services. Few people access financial services in Sudan, with only about 7 percent of the adult population having a bank account (versus 24 percent among LICs and other Sub-Sahara African (SSA) countries). Such access is concentrated in Khartoum, even though two-thirds of Sudan’s population lives in rural areas. Although documentation standards for accessing financial services have been eased, they remain difficult to meet for most Sudanese.22

30. Some access to financial service indices have been improving in recent years, but they are still at very low levels, even when compared against peer UCs. For example, even though the number of banks per 1,000 km2 has risen from 0.19 in 2004 to 0.26 in 2011, the average for SSA countries is 0.90 and 1.20 for LICs in general. Over the same period the number of branches per 100,000 of population has gone from 2.01 to 2.37 (versus an SSA average of 3.40 and LIC average of 2.50).

Also, small and medium enterprises face difficulties accessing credit markets. This is partially because banks, facing poor accounting and managerial controls in many companies, rely on onerous collateral and guarantee requirements, and on the borrower’s personal financial health. Also, according to the most recent World Bank Doing Business survey Sudan scores very low on contract enforcement23

Policy Constraints Imposed by Financial Shallowness and the CAP on Bank Holding of Government and CBOS Securities

31. Sudan’s shallow financial system and the cap in place on commercial bank holding of government and central bank securities constrain its macroeconomic policy options.

32. Shallow financial markets impact the real economy negatively, making it more difficult for firms and households in Sudan to access financial services, leading to:

  • Higher volatility: One of the key functions of banks—to enable agents, including households, to smooth consumption over time—is not performed the underdeveloped Sudanese banking system. Shocks—droughts for instance—have to be fully absorbed by a household’s existing assets, and should they be insufficient, adjustment has to be instantaneous, leading in extreme cases to destitution or worse. In fact, a shallow banking system tend to create pro-cyclical financing conditions, providing the private sector with credit in good times, but cutting it back in bad times, accentuating volatility. Financial sector development can help alleviate these liquidity constraints, thereby ultimately reducing volatility.
  • Lower growth: Financial development affects economic growth by facilitating the mobilization of savings to finance investment and by contributing to a better allocation of resources. Rioja and Valev (2004a)24 find that finance boosts growth in rich countries primarily by speeding-up productivity growth, while finance encourages growth in poorer countries primarily by accelerating capital accumulation. The impact is also nonlinear, with countries with very low levels of financial development experience very little growth acceleration from a marginal increase in financial development, while the effect is larger for rich countries and particularly large for middle-income countries. This means that a deepening of the financial system going forward could help spur growth in the Sudanese context.

33. From a policy perspective, the constraints on fiscal policy of a shallow financial system and the cap on bank holding of government securities are multiple, making fiscal and monetary policy largely procyclical and unstable. Fiscal policy effectiveness will be impacted through the following channels:

  • Liquidity risk: With debt issued with short maturities, liquidity risks faced by the government are significant. Should liquidity dry up, the government would be in a difficult position to roll over its debt, and may have to finance itself through arrears for instance, turning a fiscal issue into a financial stability risk (if arrears are to banks) or a risk to private sector development (if arrears to suppliers). Short maturities also expose to significant interest rate risks.
  • Fiscal cost: A deeper financial market, by creating more liquidity and allowing for economies of scale in debt issuance, may reduce the marginal cost of borrowing to the sovereign. These costs tend to be high presently, particularly for longer maturities.
  • Scope for counter-cyclical policy: Sudan’s economy is susceptible to shocks. This puts a premium of fiscal flexibility and fiscal space. A deeper financial system and removal of the cap on commercial bank holding of government securities would give the government more scope to run counter-cyclical policies in the event of a shock; this would allow more time to adjust to the shock, avoiding costly adjustment particularly on the part of the population that lives close to the subsistence level and has itself limited access to credit. It would also avoid delaying investment projects, which generally results in higher costs (beyond lost output in the medium term).

34. Shallowness and the cap on commercial bank holding of government and central bank securities also hamper monetary policy formulation, implementation, and effectiveness. Four transmission channels are generally distinguished: The bank lending channel; the interest rate channel; the asset price channel; and the exchange rate channel. To be efficient, all channels require functioning financial markets. Research on monetary transmission in LICs25 shows that for all the channels to be effective, a country should have a strong institutional setup, an independent central bank, a high degree of capital mobility, a floating exchange rate, and a well functioning interbank, government securities, equities and real estate markets. Most of these preconditions are not met in the Sudan, impeding monetary policy. The factors hampering monetary policy in particular include:

  • Persistent excess liquidity: The Sudanese banking system is highly heterogeneous and segmented, including with regard to the distribution of liquidity. The reluctance of banks to trade liquidity means that liquidity needs from illiquid banks need to be met by injections from the central bank. In addition, banks also tend to hold large precautionary excess reserves due to weaknesses with the payments system (e.g., remote branches may need to hold large cash balances due to transportation problems). Such a context makes it very hard for the central bank to focus on overall liquidity management. As a result, monetary policy implementation is limited to direct instruments such as changes to reserve requirements and statutory liquidity ratios (as opposed to market-based instruments such as open market operations). Furthermore, in the absence of vibrant money markets banks maintain high precautionary liquid asset balances. In addition, in the absence of interbank lending markets, the CBOS lacks flexible means to mop up excess system liquidity. Shallow banking systems also tend to create pro-cyclical financing conditions, providing the private sector with credit in good times, but cutting it back in bad times, accentuating volatility.
  • Credit rationing: Imperfect information is an important issue in Sudan, in particular for households and smaller firms in the sizable informal sector, including those located outside Khartoum. When a financial institution tightens credit extension following a tightening of monetary policy, it may increase the riskiness of new lending due to adverse selection. If unwilling to accept higher risk, the bank may ultimately decide to keep its lending rates unchanged, muting the impact of monetary policy decisions.
  • Restriction on commercial bank holding of government and central bank securities: The restriction forces government to resort to inflationary central bank financing of the budget and a loss of monetary control. Caps on direct central bank lending to the government and directing all of the government’s domestic borrowing to the domestic commercial banks and domestic securities market without any restrictions on their holdings of government securities would help the central bank regain control over the money supply. This would also help the development of the domestic financial markets and secondary trading in government securities, which are hampered by the current cap on commercial bank holding of government securities. Removing this cap on commercial bank holding of government and central bank securities would also facilitate the development of a proper central bank liquidity management framework by allowing commercial banks to hold central bank instruments intended for managing liquidity, and by allowing the central bank to use outright sale and purchases of government securities in the primary or secondary market to manage market liquidity.

Conclusions and Policy Recommendations

35. While the secession of South Sudan did not have a large impact on the North Sudanese banking system, the second round effect has probably been larger than it appears. With the loss of large oil revenues, the role of the financial system as a driver of diversification and growth is bound to become ever larger. This note illustrated that the shallowness of the financial system has both retarded growth, and reduced the effectiveness of fiscal and monetary policy in mitigating shocks to the financial system and the real economy. The large CBOS/government banking sector footprint remains a concern, with only about 10 percent of aggregate banking sector assets being owned by fully privately-owned institutions. This raises conflict of interest concerns, and it is recommended that a drive to full privatization be pursued.

36. Access to finance needs to be enhanced to promote growth. Challenges confront individuals and business enterprises in accessing credit. In part it is because banks are concentrated in Khartoum, whereas most of the population is rural. Non-deposit taking microfinance institutions can play an important role in reaching out to rural areas, but they face funding challenges too.

37. The current restriction on commercial banks’ holding of government and central bank securities should be removed. It amplifies the constraints on Sudan’s macroeconomic policy options posed by the shallow financial system. It severely limits the government’s scope in the event of a shock to run counter-cyclical policies and reducing the adjustment costs, including for the most vulnerable part of the population. It also severely impedes monetary policy and monetary control, including by forcing government to resort to inflationary central bank funding, hampering development of the security market, and restricting the few available market-based instruments available to the central bank to manage liquidity and controlling inflation. Concerns over government domestic borrowing possibly causing a crowding out of credit to the private sector should be addressed by reducing the fiscal deficit not preventing lenders to lend to government.

38. Supervisory weaknesses also need to be addressed, with the aim to move to risk-based supervision high on the agenda. While banks do not deal in sophisticated financial products, the secession, risk environment and challenges of supervising Islamic banks require an even better tailored supervisory and regulatory architecture.

39. The large commercial bank holding of excess liquidity at the central bank poses a risk to monetary control and require a careful sequencing of reforms. It could result in an excessively large credit and broad money expansion that would put further pressure on the exchange rate and inflation if put into circulation. Improving the traction of monetary policy would require measures to mop up the excess reserves, and once achieved, putting in place a better functioning interbank market.

40. Progress has been made in dealing with the weaknesses in bank supervision, inspection and enforcement identified by the 2005 FSAP but some remain. However, the central bank is making good progress in moving towards best practice, including with the assistance of the IMF’s Middle East Regional Technical Assistance Center (Box 3).

41. There is currently no legislative and regulatory framework for the securities market, and institutions to implement it. Furthermore, the Khartoum Stock Exchange is self-regulated under laws that have not been amended since 1994. However, new securities market legislation is currently working its way through the system that will rectify these deficiencies.

Box 3.Bank Supervision Recommendations

Although the CBOS has made many efforts to improve the quality of its oversight function over banks and financial companies, substantial steps are still needed to move the supervision from a compliance-based exercise to a more risk-based practice. The main actions that would be required by the CBOS can be summarized as follows:

  • 1. The current structure of the offsite supervision unit should be reviewed with an eye towards limiting redundancies and enhancing effectiveness.
  • 2. The risk-based manuals for offsite and onsite supervision need to be updated, and supervisors trained on them
  • 3. An annual supervisory plan for each bank should be developed. For this purpose, the offsite supervision unit should establish an early warning system in which it analyzes regular data on banks and the banking sector and produces timely reports on their performance and the actions that need to be taken in this respect. The onsite supervision unit should prepare an annual risk-based inspection plan that allocates the resources of the directorate according to the risk of the banks and financial companies and their impact on the overall financial stability. The offsite and onsite supervision units should establish regular formal and informal coordination arrangements to perform a comprehensive assessment and monitoring of banks and to prepare the supervisory plan for them accordingly.
  • 4. Review the current division of responsibilities within the banking supervision department and between it and other CBOS departments to allow more effective regulation and supervision of banks and financial companies and to enhance the coordination between the onsite and the offsite functions.
  • 5. Develop the CBOS bank enforcement framework through: (i) developing enforcement regulations and manuals, (ii) setting up the institutional framework and responsibilities for monitoring weak banks and taking enforcement actions against them; and (iii) building the capacity of supervisors to implement the new enforcement framework.
Annex: Islamic Banking Terms Used in this Report26

42. Islamic banking refers to a system of banking or banking activity which is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called Rlba in Islamic discourse. Instead, profit-and-loss sharing arrangements (PLS) or purchase and resale of goods and services form the basis of contracts. In PLS modes, the rate of return on financial assets is not known or fixed prior to undertaking the transaction. Islamic law also generally prohibits trading in financial risk (which is seen as a form of gambling). In addition, Islamic law prohibits investing in businesses that are considered haram (such as businesses that sell alcohol or pork, or businesses that produce un-Islamic media).

Bai salam is a contract in which the buyer pays the seller the full negotiated price of a product that the seller promises to deliver at a future date (pre-payment, deferred delivery).

Ijara is a contract in which a party leases a particular product for a specific sum and a specific time period (lease, lease-purchase). In the case of a lease purchase, each payment includes a portion that goes toward the final purchase and transfer of ownership of the product.

Istisna is a contract in which a manufacturer (contractor) agrees to produce (build) and to deliver a certain good (or premise) at a given price on a given date in the future (deferred payment, deferred delivery). The price does not have to be paid in advance (in contrast to Bai Salam). It may be paid in installments or part may be paid in advance with the balance to be paid later on, based on the preferences of the parties.

Mudarabah is a contract in which a Rabb -ul- mal provides the entire capital needed to finance a project while the entrepreneur offers his labor and expertise (trustee finance contract). Profits are shared between them at a certain fixed ratio, whereas financial losses are exclusively borne by Rabb -ul- mal. The liability of the entrepreneur is limited only to his time and effort.

The Murabaha is a contract in which the seller informs the buyer of the cost of acquiring or producing a specified product (mark-up financing). The profit margin is then negotiated between them. The total cost is usually paid in installments.

Musharakah is a contract in which a bank enters into an equity partnership agreement with one or more partners to jointly finance an investment project (joint project). Profits (and losses) are shared strictly in relation to the respective capital contributions.

Qard Hassan is a zero-return funding transaction that the Qur’an encourages Muslims to make to the needy. Banks are allowed to charge borrowers a service fee to cover the administrative expenses of handling it. The fee should not be related to the amount or maturity.

1Aggregate holdings of such investments are currently around 20 percent. Banks not yet complying with the limit have until September 30, 2013 to comply. This cap severely constrains the ability of the central bank to conduct monetary policy.
2See Shi, Haiyan, 2013, “Monetary Transmission Mechanism in Sudan,” 2013 Sudan Article IV Staff Report Selected Issues Papers(Washington: International Monetary Fund).
3Banks have been classified by ownership according to controlling interest, defined as holding more than 50 percent of equity.
4The three SFIs are the Agricultural Bank of Sudan (ABS), the Industrial Development Bank and the Savings and Social Development Bank (SSDB). The ABS supplies about 53 percent of the bank financing of the agricultural sector. The SSDB specializes in supporting microfinance activity.
5Murabaha are instruments in which a financer purchases good with agreement on resale at a price based on initial cost plus a mark-up (see annex for more detail)
6The TA project is aimed at enhancing the credit registry function through five phases: 1) adding more demographic data; 2) linking related parties to borrowers; 3) adding more financial information; 4) creating management reports and a new credit report template that would allow for the inclusion of expanded credit and demographic data along with other features; and 5) the migration of borrower codes and financial data from a test database to live production database. Major progress has been achieved towards the completion of the five phases of the project.
7Future plans include setting up a credit scoring system, similar to the “FICO” scores used in the United States, although those plans are still in their infancy. Also, data collection may be expanded to include non-banks (e.g., insurance and microfinance institutions) and the stock exchange.
8The BDSF was established in 1996 with a coverage limit of SDG 1,000 on current and savings account, and 250 on investment accounts. The current levels were set in 2010 and further increases are being considered. SDG 10,000 is roughly equal to the country’s GDP per capita and about $2,000 based on current exchange rates.
9The Ministry of Finance and CBOS also each contribute an amount equal to 15 percent of total premia collected from the banks.
10Owing to the charitable, voluntary nature of the business, company profits on underwriting and policyholders’ receipt of payouts are tax free, whereas profits on investment income are taxable.
11Shareholders—as opposed to policyholders—may not profit from the insurance business, for example, by receiving dividends, but may receive a fee for management services. In addition, it has been argued that shareholders can share in profits on the invested reserves, as distinct from the underwriting business itself. Investments must be in Sharia-compliant instruments.
12“The scope of regulation and supervision is defined by the Insurance Supervision Act, which is missing many key elements of a modern insurance supervision regime. However, the focus of the law is on regulation and compliance, and the supervisor does not have the mandate or powers to undertake a thorough analysis of possible financial and operational risks. Consequently, in practice, the ISA has limited scope to go beyond compliance oriented functions, go through the operations of the companies, and the requisite expertise and capacity to perform these functions have not been developed in its staff. Consideration should be made to move to a more independent and risk based supervisory and regulatory model with a suitable transition period. The model should be built around three pillars - solvency, governance and policyholder’s protection. The sector should strengthen on-going supervisory capacities through increased suitable staffing in the Insurance Supervisory Authority (ISA) and encourage the development of insurance institutions to train insurance staff in insurance principles. Sudan should also encourage the development of specialist insurers (agriculture, bank assurance and micro life/ health insurance etc.)”
13Also, in 2011 the CBOS and the Islamic Development Bank partnered to allocate around $62.5 million for funding, technical assistance and information technology to the sector.
14This push also includes the establishment of the Higher Council of Microfinance, headed by the First Vice President, and the launch of the 2013-2017 Comprehensive National MF Strategy.
15Two government-owned banks, the Saving & Social Development Bank and Agricultural Bank, specialize in MF lending.
16NPLs on MF funding transactions average about four percent. Typical microinsurance policies add about 1 to 3 percentage points to the annual cost, and cover 75 percent of losses.
17The Youth Microfinance Institution was established in 2010, and the AL-Amal Women’s Microfinance Institution in 2013, by their respective trade unions. The former is in the process of becoming a deposit-taking microfinance bank.
18Market capitalization, including government securities, was about $3 billion at end-2005. This equates to about 12 percent of GDP, which was in the lower third of the selected Middle East and North Africa stock exchanges evaluated in Hearn, Bruce, Jenifer Piesse, and Roger Strange, 2011, “The Role of the Stock Market in the Provision of Islamic Development Finance: Evidence from Sudan,” Emerging Markets Review, Vol. 12, pp. 338-43.
19During the first half of 2013, the trading of government certificates accounted for 96 percent of trading volume, and the trading of one stock (Sudatel) accounted for 50 percent of the other 4 percent of total volume. Sudatel is a Sudanese telecommunications firm about 60 percent owned by the government.
20The 2005 FSAP recommended the separation of control and supervision from the administrative and executive functions of the market but this is yet to be implemented.
21The latest version of the IOSCO Objectives and Principles document (June 2010) can be downloaded at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf. The FSAP also thought that there was insufficient surveillance or investigative expertise available to the KSE; and no market-oriented criminal legislation. Furthermore, there was little or no cooperation with regulators of overseas exchanges where Sudanese shares are traded
22Prior to the reform process started in 2012, to open a savings account national identity cards and a proof of residence were required, and for a checking account proof of insurance and employment, a minimum opening balance far exceeds the per capita national income was required, and banks were not allowed to operate during afternoons. Now only the identity cards and a minimum balance of SDG 50 are required, although SDG 50 is still a large sum of money for most Sudanese. Also there are actually no national financial identity cards. Prospective depositors must obtain the required identity card from the central bank through their local bank.
23Sudan ranks 143rd out of 185 countries on the World Bank “ease of doing business” index, 151st on contract enforcement, and 158* on investor protection.
24Rioja, Felix and Neven Valev, 2004. “Finance and the Sources of Growth at Various Stages of Economic Development,”£cono™’c Inquiry, Vol. 42(1), pp. 127-140
25Based on a stylized presentation for LICs in Mishra, Prachi, Peter J. Montiel, and Antonio Spilimbergo (2012), “Monetary Transmission in Low-Income Countries: Effectiveness and Policy Implications,” IMF Economic Review60, 270-302.
26Everything in this annex is taken verbatim from Appendix I of Cihak, Martin and Heiko Hesse, 2008, “Islamic Banks and Financial Stability: An Empirical Analysis,” IMF Working Paper 08/16 (Washington: International Monetary Fund).

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