Building Integrated Economies in West Africa

Chapter 22. Financial Sector Stability

Alexei Kireyev
Published Date:
April 2016
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Patrick Imam and Christina Kolerus 

Financial stability is critical for the proper functioning of the financial system and is critical for growth. In the West African Economic and Monetary Union (WAEMU), a significant strengthening of the regulatory and supervisory framework is necessary to address existing and new risks. The emergence of regional banking groups requires the development of supervision on a consolidated basis and the strengthening of cooperation with banking supervisors in countries where these groups operate. The increasing exposure of banks to sovereigns is also a risk that needs to be recognized, including through a nonzero weight on government paper in capital adequacy calculations. Microprudential regulation should be revised to bring certain prudential standards closer to international best practices, for example on risk concentration, classification of claims, and provisioning, while taking into account the regional context. The move to Basel II would help address many of these issues. The WAEMU’s financial crisis prevention and management framework needs strengthening. Crisis prevention requires greater transparency, including through the regular and timely compilation and publication of financial soundness indicators for all member countries. Regular stress tests would be a welcome step toward the introduction of an early warning system. There is also substantial scope for improving the bank resolution framework, which would reduce the budgetary cost of government intervention. Swift action in this area, including by giving broader powers to the supervisor and close collaboration with other supervisors in the case of cross-border groups, is necessary.

Obstacles to Financial Development

Strong financial crisis prevention and management frameworks are critical in a region like the WAEMU (see Wagner 2010). WAEMU countries are affected by frequent and often asymmetric shocks. As shock absorption mechanisms are limited, economic agents face substantial macroeconomic volatility that can test the stability of the financial sector (see Kolerus and Zdzienicka 2013). Other issues, such as asymmetric information and weak judicial and business environments, impose extra risks for financial institutions. Such a context requires a strong microprudential framework, adapted to the risky environment, and strong bank supervision to enforce it and detect problems early. These should be completed by adequate macroprudential surveillance to address systemic risks.

The obstacles have been well identified by the authorities and described in detail in the pilot studies on Senegal (Imam and Kolerus 2013) and Benin (IMF 2012). They include: imperfect information on borrowers, due to limited availability of audited company statements and absence of credit bureaus, leading to adverse selection and moral hazard issues, and ultimately to credit rationing; weak business and judicial environments, including the absence of formalized property rights in large parts of the countries, which increases the difficulty of using land as collateral in lending; a tax regime that is not favorable to financial activities; and insufficient financial skills and expertise. The responsibility for addressing many of these obstacles rests with the national authorities (for example, improving judicial systems). The rest of this section will focus on obstacles for which the responsibility rests to a large extent with the regional authorities.

The Central Bank of West African States (BCEAO) and staff agree that the development of key regional markets, such as the interbank market and the secondary government debt market, is a priority. The BCEAO expects major reforms in this area to be launched by mid-2013. These reforms include the introduction of collateralized operations (repos) to address the reluctance of liquid banks to lend to illiquid ones; the rollout of an electronic platform to auction and trade liquidity and government paper (application Trésor); and the introduction of primary dealers, which should accelerate the development of the secondary government debt market. A regional debt agency (Agence UMOA-Titres) has been launched with the main mission of advising national treasuries on debt management, improving issuance coordination, and contributing to the development of the government debt market. It is expected to facilitate liquidity management. Broadening the investor base in the government debt market is highly desirable; governments will face lower rollover risks and interest rates and might be able to extend maturities.

Policies aimed at the development of the government debt market may have hampered development of the private debt market and led to mispricing of risks—two issues that will need to be addressed. Distortions include tax advantages for sovereign paper, zero-risk weighting for government bonds, and eligibility for refinancing at the BCEAO. Now that the (primary) government debt market has taken off, a more balanced approach may need to be considered. At a minimum, governments should avoid providing new incentives/distortions in favor of government paper. A more level playing field with regard to taxation and riskiness would be desirable.

Recent reforms are expected to contribute to financial market development. The Conférence Interafricaine de la Prévoyance Sociale recently introduced a set of measures to (1) improve the quality of financial information, (2) develop skills and awareness toward equity finance of economic actors, and (3) lower the high entry costs to the equity market. More specifically the measures cover:

  • Introduction of ratings—Before 2012, corporations that wanted to issue bonds on the regional market were required to provide a 100 percent guarantee to investors. Those guarantees added about 1 to 2 percentage points to interest rate costs. The reforms abolish the guarantee requirement if the company is rated investment grade or higher. For companies with lower ratings, the guarantee requirement remains, but may be less than 100 percent. Currently, all private issuances are from companies that are rated lower than (local) investment grade. There are, however, a number of companies in the WAEMU that are rated above investment grade. These companies currently use their ratings to improve their credit conditions vis-à-vis banks rather than issuing on the securities market. As the problems with rating agencies during the subprime crisis have illustrated, ratings are no panacea, but they can help in other circumstances (in particular, to reduce information asymmetries); they have yet to be fully accepted in the region, as companies are reluctant to disclose information and data.
  • Enabling mortgage refinancing and securitization operations—Two financial agents have been granted securitization licenses. The WAEMU member states are currently reviewing options in this area.
  • More competitive pricing—Commissions and fees on equity issuance, which were previously at very high levels even in international comparison, have been significantly reduced to improve access to the market and attract new clients.
  • Introduction of a new electronic data management system—This includes a surveillance mechanism of the secondary market.
  • Promoting innovative forms of banking—This includes mobile banking (and products) that are adapted to the local environment.

Further reforms to improve market infrastructure and access are to be implemented in 2013–14, such as the shift to continuous trading and the introduction of a market for small and medium-sized enterprises with lower fees and less stringent rules (for example, on accounting records). The supply of financial assets can also be increased if governments list public companies and ensure that the 20 percent floating requirement—at least 20 percent of the company’s stock must be listed—be strictly enforced. In addition, the Bourse Régionale des Valeurs Mobiliéres is in talks with the stock exchange of Ghana and Nigeria for closer cooperation.

Information quality and dissemination are critical for the development of financial activities. From this perspective, ongoing work on the establishment of credit and guarantee bureaus is welcome and should be accelerated. Staff noted that the willingness of having a regional approach to this issue, while understandable, should not lead to excessive delays. Efforts at all levels to improve data quality, coverage, and timeliness should continue. The data should be widely shared at the national and regional levels between the authorities and with the public. Also, market abuse regulations—such as those that regulate against insider information—currently under discussion should be introduced as soon as possible.

Close coordination between the national and regional levels is required to ensure that the regional policy framework is sufficiently responsive to new needs. As indicated in Imam and Kolerus (2013), the Senegal report, these new needs are likely to emerge first at the national level. When a country is at the forefront of financial sector reform, the need to develop or amend the policy framework at the regional level may slow financial development in that country. While there are positive externalities for other countries from a regional approach, the time needed for developing it should be limited to a minimum.

Microprudential Regulation

Compliance with microprudential norms needs to increase through strengthened supervision. The persistence of a situation of partial compliance suggests enforcement weaknesses and poses a reputational risk to the Banking Commission. Part of the problem is insufficient resources, which, for instance, do not allow the Banking Commission to meet its objective of an on-site inspection for each bank every two years. The recent increase in staff resources should contribute to improving the situation, although it may not be sufficient. The Banking Commission will also need to have the power to impose sufficiently elevated pecuniary penalties that would deter in-appropriate behavior of banks. The supervision of state-owned banks will also need to be reviewed and strengthened to eliminate any (even apparent) political interference. Finally, it is critical to improve reporting, including for supervision purposes.

A number of regulatory standards and practices will need to be introduced or brought closer over time to best international practice. More specifically, the following areas need to be covered:

  • Concentration risk—The current ratio sets a limit to single-risk exposure at 75 percent of capital, rather than the international norm of 25 percent. Stress tests clearly show that concentration risk is the main threat to the banking system. The 75 percent limit needs to be brought down progressively to international norms.
  • Nonperforming loan classification and provision—While international norms classify a loan as nonperforming after 90 days of nonpayment, a looser definition of 180 days is used in the WAEMU. This suggests that the nonperforming loan situation could be even worse than implied by the current high ratios. Provisioning requirements may also need to be tightened, as currently no provisioning is needed for two years for nonperforming loans when the initial credits were provided with guarantees. The authorities may want to take advantage of the planned changes in bank accounting and transition to International Financial Reporting Standards (IFRS) standards to change these rules.
  • Sovereign risk weighting in capital requirements—The recent crises in Côte d’Ivoire, Guinea-Bissau, and Mali clearly show that sovereign debt cannot be seen as riskless in the region.
  • Broadening application of capital requirements—This would allow for the inclusion of other risk categories besides counterparty risks, such as market risks (even though still limited at this juncture) and operational risks, which seem to be relatively high in the WAEMU (see also Demirgüç-Kunt et al. 2008).
  • Timeliness and transparency of information—The quality and timeliness of data collected for analytical and prudential purposes need to improve, and must be disseminated to the markets.
  • Ensuring an adequate regulatory perimeter—It will be important that the regulatory net be cast wide enough so that borrowers and lenders do not shift their activities to markets that are unregulated or insufficiently regulated. Pyramid schemes, such as those discussed in the Benin pilot (IMF 2012), could thereby be more easily prevented.

The authorities intend to address many of these issues in the context of the transition to Basel II. They expect to launch this multiyear project shortly and expressed interest in technical assistance from the IMF in this area. Progress was made in reforming two prudential norms that were of questionable effectiveness. With regard to the concentration risk, a concern is that it reflects the fact that the formal sector remains relatively narrow. Lowering the risk-division ratio should therefore be done gradually, and in a way that does not affect the provision of financing to key economic sectors.

Risk will need to be monitored on a consolidated basis to capture the full spectrum of activities undertaken by large, complex financial groups. The Banking Commission currently has limited capacity to conduct prudential oversight of complex and rapidly expanding pan-African banking groups. Consolidated supervision is also hampered by the Banking Commission lacking powers to supervise financial holding companies. These shortcomings must be addressed force-fully. The authorities are aware of these issues, which have also been identified recently by the FSC. A study on how to move toward consolidated supervision is being prepared.

Adequate supervision of cross-border groups also requires a strengthening of collaboration with other supervisors. There are currently a few cross-border cooperation agreements (for example, with France, Guinea, and Morocco), with several ones being worked out. Such agreements are welcome. However, the effectiveness of such agreements is not assured in a crisis context, as illustrated in other regions during the international financial crisis. Improved collaboration with foreign supervisors would require: (1) signing cooperation protocols with the full range of foreign supervisors of parent banks and subsidiaries of lending institutions located in the Union (at present only half a dozen protocols have been drawn up and signed); (2) setting up a schedule of regular meetings with foreign supervisors structured according to types of risks; (3) instituting a regular sharing of information between supervisors, in particular regarding the assessment and monitoring of risks and internal auditing within corporate entities; and (4) in collaboration with foreign supervisors, clarifying the actual responsibilities of parent companies in recapitalizing their branches and subsidiaries, especially when problems arise. The authorities could therefore consider: (1) taking the lead in proposing and organizing supervisory colleges for each of the pan-African banking groups; (2) coordinating with the Nigeria supervisory authorities the formation of college groups for Ecobank and the United Bank for Africa; and (3) heading a review of the legal obstacles that may hinder the sharing of information across different supervisory bodies. At the WAEMU level, the existing college of supervisors is essentially a working group that can share information and promote harmonization, but not a supervisory college with the mandate, power, organization, and capacity to monitor and inspect the activities of each banking group headquartered in the region.

Macroprudential Regulation

An important lesson from the global financial crisis is the need to supplement microprudential policies with macroprudential ones. Taken together, these policies help enhance the shock absorbers in the financial system in terms of capital and liquidity, place constraints on overall leverage and extend the regulatory perimeter to all systemically important institutions, markets, and instruments (Table 22.1).

Table 22.1Macroprudential and Microprudential Policies
Proximate ObjectiveLimit financial system-wide distressLimit distress of individual institutions (solvency risk)
Ultimate ObjectiveMinimize output costsConsumer (investor/depositor) protection
Model of Risk(In part) endogenousExogenous
Interconnectedness and SubstitutabilityImportantIrrelevant
Calibration of Prudential ControlsIn terms of system-wide distress; top-downIn terms of solvency risk; bottom-up
Source: International Monetary Fund 2010.
Source: International Monetary Fund 2010.

Macroprudential surveillance is recent in the WAEMU and needs to be strengthened in the following areas:

  • Early warning systems—The BCEAO has initiated work on this issue, but is facing a number of data and methodological issues. Financial data are scarce and their informational content might be limited because of the shallowness of markets. In addition, the past might be a poor guide for estimating an early warning system, as a number of banking/financial crises in the region may have been caused by (exogenous) shocks difficult to foresee (for example, political crisis, governance issues).
  • Coverage—Sectoral balance sheets (household, corporate, financial institutions, and public sectors) are often critical for financial stability analysis but are not readily available in the WAEMU. This gap could be partially filled through the use of targeted surveys of firms, households, and corporations. Cross-border linkages also need to be monitored more closely and analyzed. Financial network risk analysis could be used for the map of risks in the financial sector that the authorities are currently designing. Finally, coverage of other nonbank financial institutions, such as insurance companies and pension funds, will need to expand.
  • Disaggregation of information—The use of aggregated data can sometimes mask pockets of vulnerabilities. For that reason, financial stability analysis should also rely on disaggregated data to estimate the distribution of risks across sectors. For example, analyzing the breakdown of borrowing by industry and region can be informative. Analysis of disaggregated data on banks can also be critical given the heterogeneity of the banking system, and could be used actively by the Banking Commission to develop risk-based supervision.
  • More active use of stress testing—The regional authorities have decided to develop their capacity in this area. Once they have become familiar with basic stress testing and improved the quality and timeliness of data, they could explore ways to refine the exercise, including by incorporating macroeconomic variables and developing a range of plausible scenarios.
  • Publication of information—The recently established Financial Stability Council (FSC) could consider producing and publishing a financial stability report to communicate and convey to economic agents the risks and challenges faced by the financial system. Consideration could be given to making disaggregated data publicly available.

The range of macroprudential instruments will need to be expanded (see Hansen 2012). Reserve requirements are presently the only instrument available to the authorities. Reserves requirements have been harmonized and, therefore, cannot be used to address asymmetric shocks. The authorities will therefore need, at some point, to consider broadening their toolkit with other instruments. Given the limited correlation between macroeconomic variables and financial ones—business cycles in WAEMU countries are often driven by weather-related or political shocks that cannot be forecasted—introducing instruments to address these risks (such as countercyclical capital requirements) would not necessarily be effective at this juncture. In staff’s view, while macroprudential policies could play a very useful role in a heterogeneous region, more urgent tasks for the authorities include: (1) developing a monitoring system, which is a prerequisite; and (2) improving microprudential regulation and supervision.

Crisis Management

In a financial crisis, emergency liquidity assistance may need to be provided to illiquid but solvent institutions. Emergency liquidity assistance is distinguished from the normal provision of liquidity to individual institutions under the central bank’s standing facilities. While standing facilities are available on demand and the rules of access are clear ex ante, emergency liquidity assistance is typically available only in exceptional circumstances at the discretion of the central bank, with adequate but unconventional collateral.

The BCEAO currently does not have an explicit mandate to provide emergency liquidity assistance. The ambiguity arising from this situation may be a double-edged sword. While the absence of a mandate protects, in principle, the BCEAO’s balance sheet, historical evidence suggests that it is hard for a central bank to avoid getting involved in a systemic liquidity crisis. Once this happens, the risk to the central bank’s balance sheet might actually be much more difficult to contain. To avoid such a situation, it would be desirable for the BCEAO and the national governments to discuss ex ante how the BCEAO could get involved in the provision of emergency liquidity assistance and how it would be indemnified by the governments for this activity should losses arise.

Where a financial institution’s problems extend beyond short-term liquidity and are more deep seated, recourse to recovery or resolution strategies is needed in which regulators and management work together to address the underlying problems, and so, maintain the firm as a “going concern.” If this fails, a resolution strategy to close the firm in a structured and orderly way should be developed. The objective in each case will be to minimize the impact on the rest of the financial system, and by doing so, help sustain the provision of essential services to the economy. In both cases, the cost to the budget will also be an important consideration.

The Banking Commission needs to improve detection of early problems and to rely more on prompt and forceful corrective action. An effective supervisory framework requires that problems are detected early on and that this is followed by early intervention in the form of prompt corrective action to restore an institution’s health. As discussed earlier, the authorities need to use financial and prudential information from institutions much more proactively so as to be able to anticipate better problems and move to risk-based supervision; this will also require better reporting. Their track record suggests that problems have been permitted to persist longer than is desirable. Many banks in the WAEMU have indeed been insolvent for long periods without the situation being resolved. These “zombie banks” have incentives to gamble for resurrection and can have an adverse impact on other banks. More forceful action would therefore be desirable in the future, including with a view to reducing intervention costs. Absent a robust and effective resolution regime, the WAEMU authorities have little choice but to bail out such banks at great public expense—which perpetuates moral hazard.

In case a bank cannot be recovered, it must be closed down, but the WAEMU resolution regime lacks key attributes recommended by the Financial Stability Board (Table 22.2). Adopting some of the Financial Stability Board recommendations would require strengthening the powers of the regulator. For instance, the Banking Commission, acting within a well-defined framework that protects the rights of depositors and creditors, would be able without undue delay to order the transfer of assets and liabilities, undertake mergers, and decide on changes in shareholders.

Table 22.2The Financial Stability Board’s Recommendations for Effective Resolution Regimes: Where Does the WAEMU Stand?
Key Attributes for Resolution RegimesEnsure continuity of systematically important financial services, and payment, clearing and settlement functionsProtect, where applicable and in coordination with the relevant insurance schemes and arrangements such depositors, insurance policy holders and investors as are covered by such schemes and arrangements, and ensure the rapid return of segregated client assetsAllocate losses to firm owners (shareholders) and unsecured and uninsured creditors in a manner that respects the hierarchy of claimsNot rely on public solvency support and not create an expectation that such support will be available
WAEMU StatusNot clearNot adoptedAdoptedNot adopted
Key Attributes for Resolution RegimesAvoid unnecessary destruction of value, and therefore seek to minimize the overall costs of resolution in home and host jurisdictions and, where consistent with the other objectives, losses for creditorsProvide for speed and transparency as much predictability as possible through legal and procedural clarity and advanced planning for orderly resolutionProvide a mandate in law for cooperation, information exchange and coordination domestically and with relevant foreign resolution authorities before and during a resolutionEnsure that nonviable firms can exit the market in an orderly way
WAEMU StatusNot adoptedNot adoptedNot adoptedNot clear
Key Attributes for Resolution RegimesStabilization options that achieve continuity of systematically important functions by way of a sale or transfer of the shares in the firm or of all or parts of the firm’s business to a third party, either directly or through a bridge institution, and/or an officially mandated creditor-financed recapitalization of the entity that continues providing the critical functionsLiquidation options that provide for the orderly closure and wind-down of all or parts of the firm’s business in a manner that protects insured depositors, insurance policy holders, and other retail customers
Not clearNot adoptedNot applicable
Source: Financial Stability Board 2013.
Source: Financial Stability Board 2013.

Some of the difficulties in resolving banks could reflect coordination failures between the regional and national authorities. The resolution of a bank involves the Banking Commission, which makes the decision, and the concerned national government, which needs to approve that decision. In case of a disagreement, the government can appeal to the WAEMU Council of Ministers to reverse the decision. Before-the-event burden-sharing arrangements could be designed to overcome some of the issues of delaying bank resolution. The authorities should also pursue explicit support from parent companies with respect to their branches or subsidiaries when a request for a banking license is examined, with a view to obtaining substantial resources for intervention from shareholders should the need arise. As public banks in some of the countries have often been a source of problems, privatization may also be worth considering.

To avoid moral hazard problems, a systematic investigation of the responsibilities of directors, shareholders, and auditors involved in a bankruptcy should be conducted. This should be particularly the case in instances in which public funds were engaged. Conclusions should be drawn from investigations with regard to the suitability of the concerned stakeholders for future jobs in the financial sector. Inappropriate behavior should be prosecuted to the full extent of the law.

Well-designed financial safety nets are critical to an effective crisis management system. Their mere existence may go a long way to stabilizing financial systems in times of stress. Deposit insurance systems are an important part of financial safety nets, particularly to address smaller (idiosyncratic) banking crises if not systemic ones. Credible systems are those that have appropriate coverage, timely payouts, and adequate funding.

The authorities are working on a deposit insurance system and on an insurance fund to guarantee all payments made through the real-time gross settlement system. They are still considering some aspects of coverage, payouts, and funding but expect the system to be launched in the near future. It would cover deposits with banks and microfinance institutions. IMF staff suggested that the authorities consider giving a role to the deposit insurance system in bank recovery, as is the case in a number of countries. This might allow reducing the final cost, as recovery is often less expensive than liquidation.

Finally, the authorities are working on a Financial Stability Fund, whose main goal would be to avoid possible debt payment incidents by sovereigns facing liquidity problems. Work is still ongoing on a number of key issues, such as financing of the Financial Stability Fund and terms of its financing. IMF staff flagged a number of issues to be considered, such as the identification of the nature of shocks (that is, temporary vs. permanent, which is, for instance, particularly difficult to assess in the case of political instability), how to address moral hazard (Is there a role of conditionality? Should financing be provided on market or concessional terms?), and the seniority of Financial Stability Fund financing, which could raise issues if a restructuring is eventually needed.


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