A. Structure of the Financial System

80. Zimbabwe has all the elements of a modern developed financial sector, including life and general insurance, public and private pension funds and active capital markets including the Zimbabwe Stock Exchange and twelve stockbrokers. ⁵⁶ The banking sector comprises twelve commercial banks, five merchant banks, five discount houses, four finance houses and four building societies (Table 1).

Table 1.

Financial System Structure

Source: Reserve Bank of Zimbabwe (RBZ).

^1/Converted at Official exchange rate.

Table 1.

Financial System Structure

December, 2004	Total Assets (US$ million) 1/	Percent of Total	Percent of GDP 2/
Commercial banks	2,818.62	79.6	80.0
Merchant banks	208.34	5.9	5.9
Building societies	166.33	4.7	4.7
Finance Houses	59.36	1.7	1.7
Discount Houses	42.31	1.2	1.2
Post Office Savings Bank	32.85	0.9	0.9
Insurance and Pension funds	153.16	4.3	4.3
Prescribed securities	59.34	1.7	1.7
Microfinance Institutions	..	..	..
Total Financial system	3,540.31	100	100.5

Source: Reserve Bank of Zimbabwe (RBZ).

^1/Converted at Official exchange rate.

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Table 1.

Financial System Structure

December, 2004	Total Assets (US$ million) 1/	Percent of Total	Percent of GDP 2/
Commercial banks	2,818.62	79.6	80.0
Merchant banks	208.34	5.9	5.9
Building societies	166.33	4.7	4.7
Finance Houses	59.36	1.7	1.7
Discount Houses	42.31	1.2	1.2
Post Office Savings Bank	32.85	0.9	0.9
Insurance and Pension funds	153.16	4.3	4.3
Prescribed securities	59.34	1.7	1.7
Microfinance Institutions	..	..	..
Total Financial system	3,540.31	100	100.5

Source: Reserve Bank of Zimbabwe (RBZ).

^1/Converted at Official exchange rate.

81. Commercial banks dominate the financial system, and the largest five banks (two majority domestically owned and three foreign owned) account for 65 percent of banking sector assets. The majority foreign-owned banks accounted for 45 percent of banking sector assets at end-March 2005 (Appendix 1). Bank branches are widespread as evident from a total of 429 branches at end-March 2005. Of these, 219 are building society branches while 192 are commercial bank branches, 124 of which belong to the largest five banks.

B. Weaknesses in the Banking Sector in 2003-04

82. The macro-economic developments in 2003-2004 brought to light underlying weaknesses in the financial sector. Notable among these were poor standards of corporate governance, inadequate risk-management, and the use of depositors’ funds for speculative investments. In addition, there was abusive self-dealing, including unreported insider transactions, use of subsidiaries and affiliates to evade prudential limits, and use of RBZ liquidity advances to support group companies and deliberate misreporting to RBZ to conceal losses and overstate capital. These were most prevalent and damaging in the “new generation” of deposit-taking institutions licensed in the 1990s.

83. A contributing factor to the weaknesses in the banking sector was inadequate supervision. Both the number of staff and their level of training and experience was less than required for appropriate supervision, with the further shortcoming that the ultimate supervisory authority rested with the Ministry of Finance rather than the RBZ. Thus, the independence of the RBZ was limited by the need to refer licensing decisions to the Ministry of Finance. As a result, even when serious problems were identified in the banking sector, there was more likely to be forbearance than decisive supervisory action.

84. Pressures were already evident in the banking sector by December 2003, with dependence by banks on RBZ advances having increased significantly over the year (Figure 1). Some of this nominal increase was due to the effects of high inflation, but considering that total RBZ advances increased from an amount equal to about 4 percent of bank deposits at mid-year to 15 percent at end-2003, it is clear that some banks were having increasing difficulty funding themselves with deposits (Figure 2). These pressures continued to build following the December 18, 2003 monetary policy statement, which increased statutory reserve requirements effective January 2004 from 20 to 30 percent for commercial banks.

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RBZ Liquidity Support to Banks

($Z billions)

Citation: IMF Staff Country Reports 2005, 359; 10.5089/9781451841503.002.A007

Source: Reserve Bank of Zimbabwe.

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Bank Dependence on RBZ Funding

Citation: IMF Staff Country Reports 2005, 359; 10.5089/9781451841503.002.A007

Source: Reserve Bank of Zimbabwe.

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C. Addressing the Banking Sector Problems

85. The RBZ recognized the need to address both the underlying weaknesses that had led to the emergence of problem banks, as well as to resolve the identified weak banks. A package of policy measures was introduced to address the underlying weaknesses in the system by strengthening supervision and prudential standards, and thus check the flow of new problem banks. However, the delay in intervening in some banks making heavy use of RBZ liquidity support increased losses to depositors and other creditors. Also, it appears that the decision to expend public funds for bank restructuring was not motivated by concern over the potential systemic risk, but to preserve the existing level of indigenous ownership of the banking system. Such policy decisions are within the purview of government, but it is important to identify the full cost of these policies.

86. Transferring the powers of the Registrar from the Ministry of Finance to the RBZ through the Financial Laws Amendment Act in August 2004 was one of the most important measures to enhance the soundness of the banking system. The significance is two-fold. First, having obtained the authority for bank licensing, the RBZ is better placed to ensure that potential new entrants to the market meet stringent standards, thus avoiding the problems that can be generated by licensing weak banks. Second, it enhanced RBZ’s ability to take corrective actions. Equally important in enhancing the credibility of the RBZ was the placement of weak institutions into curatorship or liquidation, which clearly signaled a break from past practices of forbearance.

87. The enhanced credibility of the RBZ was used to enforce compliance with prudential requirements and its supervisory authority was extended to include asset management companies. New prudential guidelines were issued in 2004 to establish minimum standards for corporate governance, internal audit, and the relationship between the supervisor and external auditors. Further, significant steps were taken in 2004 to strengthen the practice of banking supervision, through recruitment of new staff, ongoing training for examiners including through the Financial Stability Institute and regional seminars and the introduction of electronic submission of prudential returns and an automated system for supervisory analysis. These measures were in addition to the continuation of earlier initiatives to introduce risk-focused supervision and consolidated supervision of banking groups.

88. Decisions on problem bank resolution appear to have been driven more by the policy objective of maintaining indigenous ownership rather than concerns about systemic stability. It is possible, however, that in early 2004 uncertainty about the true state of the financial system could have raised concerns about the potential for the failure of a number of smaller banks to have a contagion effect which might threaten larger banks and hence systemic stability.

89. Provision of open-ended liquidity support is also consistent with the long-established practice of the RBZ in dealing with problem banks, dating from well before the bank problems of 2003-2004. The initial hope that banks would be able to work through their problems has proved ill-founded. Liquidity and time were not enough to address the underlying problems in many banks, and the decision to place nine licensed deposit-taking institutions in curatorship during 2004, and three other institutions in liquidation was a departure from the previous adherence to the “wait and hope” approach to problem institutions.

90. It seems clear in retrospect, even if there was uncertainty at the time, that the difficulties faced by the banking sector in 2003-2004 were not systemic. The institutions intervened in 2004 were all relatively small, collectively accounting for only about 12 percent of bank deposits and 16 percent of assets (Appendix 2). The flight of depositors to perceived quality in late 2003 and early 2004 improved the already satisfactory liquidity of the five largest banks. Considering that throughout the period of turmoil, institutions constituting the majority of the banking market remained sound and any threat of contagion was limited to smaller banks, the risk of systemic crisis was not nearly great enough to justify the provision of liquidity support to insolvent banks.

91. The decision to extend liquidity support to banks identified through on-site examinations as insolvent has proved costly, although the effects of high inflation obscure the true costs. Recoveries by curators and liquidators are impressive in nominal terms. The value of physical assets of banks (for example staff cars) as well as the chattels and property held as security for loans, has increased at or above the rate of inflation, while interest ceased to accrue on the liabilities of the institution at the date of closure. Thus, while depositors and other creditors are likely to receive significant nominal distributions from the failed banks, in real terms, the depositors and creditors have effectively lost the bulk of their claim

92. The inflationary effect of the over $2 trillion provided in liquidity support through the Troubled Bank Fund (TBF) is another hidden cost of bank restructuring. Had the problem banks been closed earlier rather provided with liquidity support, the RBZ’s efforts to tighten monetary policy would not have had to cope with this injection of money into the system. In addition to the possibility that inflation and interest rates might have been lower, earlier closure of the insolvent banks would have checked the accumulation of losses, reducing the ultimate costs borne by depositors.

93. Total liquidity support from the TBF to the banks placed in curatorship or liquidation in 2004 exceeded three times their total deposit base (as at September 2004). Not all of this Z$ 2 trillion will be lost, and in fact, if Zimbabwe Allied Banking Group (ZABG) is only moderately successful, the entire nominal loss may be more than recouped through the intended sale of ZABG shares (Box 1). Two to three years of high inflation could easily result in a nominal valuation of ZABG well in excess of Z$ 2 trillion, however, it would be a mistake to then view the Troubled Bank Resolution Strategy as a financial success.

94. The final costs to depositors, creditors and the TBF are not yet known for any of the banks placed in curatorship or liquidation in 2004. The write-down of creditors’ claims by the curators of the three banks combined into ZABG resulted in a loss to the TBF of almost Z$ 1.2 trillion, and a portion of the other $1 trillion advanced under the TBF will be lost. As noted above, it is possible that the subsequent sale of ZABG may recoup some or all of these losses in nominal terms, but in real terms, depositors and the TBF have lost the bulk of their claims (Table 2).

Box 1.

Zimbabwe Allied Banking Group (ZABG)

ZABG is a kind of “bridge bank,” incorporated to receive assets and liabilities of three failed banks, Barbican, Royal and Trust. The determination was made by the curators of each bank that potential recoveries were greater through this approach than the alternative of liquidation. The basis for the determination was primarily that the branches, physical assets and some loan assets had greater value as a going concern than in liquidation. ZABG was capitalized by the conversion of depositors and creditors claims into equity.^*

Attempts to recapitalize banks by conversion of deposits into equity frequently fail for the following reasons:

• The conversion of the deposits to equity does not address the liquidity problems of the bank

• The restructured bank continues to be hampered by poor quality assets

• Forcibly converted depositors often do not make good owners and seek to withdraw their funds at the earliest opportunity, often by taking loans which they have no intention of repaying

However, the current high inflation environment has helped to address these issues.

Recoveries by curators, aided by the inflationary environment, were sufficient to enable cash payments to be offered to depositors with balances of less than Z$5 million, and to provide the recapitalized institution with adequate opening liquidity. When invested in relatively high-yielding treasury bills, combined with the liability side of the balance sheet consisting largely of equity, the restructured bank is positioned to be profitable and liquid from the outset. The 44 branches of the legacy banks have been consolidated into 25, with 250 of 860 former staff retrenched, and about 40 new well-qualified employees recruited, including most of the senior management team. All of the operations of the three legacy banks have now been converted to a single information technology platform, which was less difficult than it might have been as two of the three legacy banks used the same system.

Notwithstanding the promising start, there are significant challenges ahead. The business plan calls for growth in the full range of financial services, and targets may be difficult to achieve against the backdrop of a shrinking economy. For ZABG to be successful, it will have to be operated on a commercial basis without political interference, notwithstanding its public ownership. A good start has already been made with the recruitment of a well qualified board of directors, but experience elsewhere indicates the strong temptation for government to use state-owned banks to implement policies of supporting specific regions and sectors regardless of commercial considerations.

The use of the powers of the curator to sell the assets of the three failed banks to ZABG has been challenged in court. If the plaintiffs (Trust Bank shareholders), are successful, the legal foundation of ZABG could be undermined. There is also uncertainty about the intended conversion of TBF loans into equity in ZABG. ZABG shows the amount as common equity, however, it does not appear that the company incorporated to hold the government shareholding, Allied Financial Services, has yet acquired either the debt or equity, which suggests the need to regularize the holding arrangements for ZABG.

Assuming that ZABG survives the legal challenges noted above, it may be used as a resolution vehicle for other banks currently in curatorship. No firm decisions have been made regarding the intended divestiture process, but it is expected that an initial public offering will be made of a minority shareholding to provide additional capital for expansion. The announced intention is to fully divest public ownership by end-2007.

ZABG Balance Sheet and Income Statement, May 30, 2005

(Z$ billions)

ZABG Balance Sheet and Income Statement, May 30, 2005

(Z$ billions)

Assets		Liabilities and Equity		Income Statement (Jan-May)
Cash, liquids	41	RBZ (PSF)	19	Interest income	106
Treasury bills	174	Deposits	127	Interest expense	1
Statutory reserves	49	Other	48	NII	105
Loans	172	Preference shares	45	Non-interest income	2
Fixed assets	82	Common shares	570	Gross income	107
Other	294	Retained earnings	3	Non-interest expense	86
Total	812	Total	812	Loan loss expense	2
				Net income (pre-tax)	19

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ZABG Balance Sheet and Income Statement, May 30, 2005

(Z$ billions)

Assets		Liabilities and Equity		Income Statement (Jan-May)
Cash, liquids	41	RBZ (PSF)	19	Interest income	106
Treasury bills	174	Deposits	127	Interest expense	1
Statutory reserves	49	Other	48	NII	105
Loans	172	Preference shares	45	Non-interest income	2
Fixed assets	82	Common shares	570	Gross income	107
Other	294	Retained earnings	3	Non-interest expense	86
Total	812	Total	812	Loan loss expense	2
				Net income (pre-tax)	19

^*Public and private ownership is 87 and 13 percent respectively.

Table 2.

Real Costs of Bank Restructuring

Source: Staff estimates from Reserve Bank of Zimbabwe data.

Table 2.

Real Costs of Bank Restructuring

	Depositors Z$ 5 million or less		Depositors over Z$ 5 million and TBF
	Change in CPI from date of curatorship to payment January 2005 (percent)	Real value of claim when paid (percent of original claim)	Haircut imposed to recapitalize the bank (percent of depositor and creditors claims)	Real value of claim after conversion to equity January 2005 (percent of original claim)	Real value of claim at end-2005, assuming 190 percent average annual inflation
Barbican	98.5	50.4	20	40.3	13.9
Royal	48.8	67.2	50	33.6	11.6
Trust	36.8	73.1	75	18.3	6.3

Source: Staff estimates from Reserve Bank of Zimbabwe data.

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Table 2.

Real Costs of Bank Restructuring

	Depositors Z$ 5 million or less		Depositors over Z$ 5 million and TBF
	Change in CPI from date of curatorship to payment January 2005 (percent)	Real value of claim when paid (percent of original claim)	Haircut imposed to recapitalize the bank (percent of depositor and creditors claims)	Real value of claim after conversion to equity January 2005 (percent of original claim)	Real value of claim at end-2005, assuming 190 percent average annual inflation
Barbican	98.5	50.4	20	40.3	13.9
Royal	48.8	67.2	50	33.6	11.6
Trust	36.8	73.1	75	18.3	6.3

Source: Staff estimates from Reserve Bank of Zimbabwe data.

95. The apparent success of the current approach to bank restructuring is misleading. The real costs are obscured by high inflation, and depositors would be better served by faster and less disruptive resolutions. Ultimately, losses on the TBF will be borne by the taxpayers. It would be more transparent for these losses to be immediately acknowledged, and accounted for as fiscal expenses. This facilitates identifying the true cost of the policy decision to provide liquidity support to insolvent banks, and so is preferable to quasi-fiscal financing by the central bank.

D. Impact of Exchange Rate Regime and Interest Rate Policies

96. Macroeconomic issues create significant challenges for the RBZ in its role as the banking supervisory authority. These have a prudential dimension, as economic contraction, volatile interest rates, high inflation and divergent exchange rates all pose serious risks to the financial sector. In addition, the attempts by the authorities to mitigate the impact on the real sector have led the RBZ to devote significant resources to enforcing regulatory requirements that have no prudential foundation.

97. The high nominal and real interest rates that have been required to counter inflationary pressures and support the official exchange rate present challenges for the banking sector (Figure 3). There are few borrowers, typically exporters or traders, who can sustain real lending rates of about 60 percent by quickly liquidating inventory or selling finished goods to repay the funds borrowed for stock or inputs. Traders pass on these high financing costs to their customers, resulting in a higher cost of goods in the real economy. Exporters, however, may find themselves unable to pass on these higher financing costs. The authorities have attempted to compensate for the lack of competitiveness induced by high interest rates and an overvalued exchange rate in part through concessional interest rates for loans to targeted sectors, and support prices for exporters.

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Commercial Bank Lending Rates

(percent)

Citation: IMF Staff Country Reports 2005, 359; 10.5089/9781451841503.002.A007

Source: Reserve Bank of Zimbabwe.

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98. These attempts to direct lending to particular sectors have created their own perverse incentives. The recipients of subsidized credit may be tempted to invest the funds in relatively high yielding government debt, or real property and goods in the expectation of earning a quick inflationary gain, rather than using credit for more uncertain commercial returns. Businesses outside the designated sectors are tempted to misrepresent their business to obtain access to credit. Those in productive sectors may borrow unneeded funds, and on-lend at a margin to borrowers unable to access credit. These abuses have led to the increasingly more stringent requirements for borrowers receiving subsidized credit. Whether fully effective or not, the additional restrictions add to the administrative burden on borrowers and banks, and require greater policing activities by the RBZ. The higher administrative burden and lower return to the banks under the new programs is likely to limit banks’ willingness to provide these facilities.

99. The binding constraint to credit expansion is the lack of bankable opportunities, which becomes more severe as the economy continues to shrink. Banks generally have excess liquidity, with liquid assets amounting to almost 50 percent of total assets at end-2004. However, high interest rates, uncertain foreign exchange rates and availability all place strains on businesses, increasing credit risk. In the personal lending market, the rapid erosion of salaries by rampant inflation makes personal (retail) lending difficult, as individuals easily able to service a line of credit when granted may have no disposable income within a few months as salary increases lag the price increases in essential expenditures on food and shelter.

100. The fragmented foreign exchange market creates distortions and perverse incentives. The crackdown by the RBZ since 2004 is said to have resulted in banks and other regulated financial institutions ceasing to trade in the parallel market. Individuals and businesses will not willingly lose the difference between the auction rate and parallel market rate, so forced surrender requirements and vigorous enforcement primarily serve to drive the transactions outside the regulated financial sector or offshore.

101. Despite holding large portions of their assets in liquid investments, banks face severe challenges in managing their day to day liquidity position. In addition to the high statutory reserve requirements, an even more punitive measure is the sweeping of banks’ accounts with the RBZ at the close of business each day, with excess liquidity applied to the compulsory purchase of two year zero-coupon 17 percent special treasury bills.⁵⁷ While serving to encourage interbank activity, this can result in severe penalties for banks unable to manage their excess reserve position to zero each day since the excess is swept into below market-rate instruments, while any shortfall must be covered through borrowing from the RBZ at the overnight rates.

102. Spreads between lending and deposit rates are inflated by the very high statutory reserve ratios. This increases the cost of borrowing, further dampening growth, and depresses the remuneration on deposits, providing a disincentive for savings. For banks making advances under concessional rate financing, the impact of the reserve requirements is mitigated because the RBZ provides zero interest advances to banks which are then on-lent. The RBZ considers these facilities to be funded from statutory reserves. Despite this, about 17 percent of bank assets are non-earning due to the reserve requirements, and a further 13 percent are in low yielding concessional rate loans, and a further portion is held in below-market compulsory purchased T-bills. This contributes to high lending rates and low deposit rates because the margin earned on about half the balance sheet has to cover non-interest expenses, the cost of unremunerated and below market rate assets, and provide a profit margin.

E. Banking Sector Soundness and Resilience

103. Given the measures taken by the RBZ, at present, the banking sector appears broadly sound and the quality of supervision generally adequate.⁵⁸ There are still some weak banks in the system although they are small and not of systemic importance. Further, these weak banks are under close scrutiny by the RBZ which has since 2004 taken more decisive action to address the problem banks. The quality of supervision has been enhanced through staff recruitment and ongoing training to enhance capacity. More importantly, decisive supervisory action has been taken to deal with identified problem banks, which is a marked improvement over the practices of regulatory forbearance evident prior to 2004.

104. The remaining banks in the system have shown remarkable resilience in the face of a difficult macroeconomic environment. As a coping strategy, there has been an increasing preference for liquid low-risk assets evident in the noticeable shift towards securities (mainly treasury bills and investments) which constituted 25 percent of total assets at end-March 2005, up from 19 percent at end-2003 (Appendix 3).

105. Consequently, balance sheet growth has not resulted in a corresponding growth in loans. Although banking sector assets have grown by 50 percent in real terms between end-2003 and end-2004, loans have increased by only 20 percent in real terms.⁵⁹ The increase in loans has largely been driven by the subsidized credit available through the Productive Sector Finance Facility (PSF), as there are few businesses able to sustain the high interest rates.⁶⁰

106. Reported asset quality has deteriorated significantly, but the evident decline is in part attributable to improved supervisory capacity and more accurate reporting by banks. A decline in asset quality is not unexpected given the adverse macroeconomic conditions. The full impact of high interest rates has been mitigated for many borrowers by the PSF loans, which has lessened the deterioration in asset quality that might otherwise have occurred. Further, the increase in adversely classified loans from about 4 percent at end-2003 to 23 percent at end 2004 likely overstates the decline in asset quality. The figure from end-2003 was almost certainly much larger than reported by many banks, while the 2004 figure is likely much closer to a true picture as a result of more stringent supervision by the RBZ.

107. Banks profitability increased marginally despite the pressures on asset quality. This reflects large spreads, increased income from investments in government securities and cost minimization through retrenchments and streamlining operations in addition to the ongoing emphasis on funding with zero-cost demand deposits.⁶¹ Depositors continue to keep funds in the banks in spite of the limited returns due to the transactions demand for money in a high inflation environment and the absence of alternatives. The return on assets for commercial banks increased from 6.1 percent at end-2003 to 9.7 percent at end-2004. The return on equity was 125.4 percent at end-2004 but this remained below the rate of inflation.⁶²

108. Loans are largely concentrated in the agriculture, distribution, and manufacturing sectors (Table 3). The exposure to the agricultural sector doubled from 11 percent at end-2003 to 21.4 percent at end-2004, largely due to the increased PSF loans causing a re-allocation from the distribution and services sector to the agriculture sector.

Table 3.

Zimbabwe Financial Soundness Indicators, 1999-2004

(In percent, unless otherwise indicated ^1/)

Source: RBZ

^1/Based on commercial banks only which account for about 80 percent of total banking sector assets.

Table 3.

Zimbabwe Financial Soundness Indicators, 1999-2004

(In percent, unless otherwise indicated ^1/)

			1999	2000	2001	2002	2003	2004
Capital adequacy
	Capital to risk-weighted assets		15.3	18.3	22.4	16.2	15.0	34.4
		Tier 1 capital to risk-weighted assets	11.9	16.9	12.1	7.1	12.4	33.4
		Capital to total assets	6.0	9.5	10.4	8.0	7.5	12.1
Asset quality
NPLs to gross loans			14.1	18.2	13.7	7.9	4.2	23.2
Total provisions to NPLs			38.9	45.4	50.0	70.5	75.5	48.6
NPLs net of specific provisions to capital			48.2	45.5	35.7	10.1	14.9	38.2
	Loan concentration
Agriculture			15.8	14.5	12.8	11.2	10.9	21.4
Construction			1.5	4.3	1.9	2.3	3.1	2.2
Communication			1.6	0.7	3.0	1.3	0.7	2.5
Distribution			17.4	16.5	27.8	23.8	22.0	15.3
Finance & investments			3.1	12.1	10.8	5.0	1.7	0.4
Financial Organizations			2.7	7.4	1.6	6.8	2.1	0.3
Manufacturing			17.6	14.0	20.6	20.9	19.1	20.6
Mining			7.2	9.7	4.4	2.5	6.0	9.5
Services			19.9	11.3	6.7	14.0	18.7	15.1
Transportation			3.3	3.4	2.3	3.3	2.3	3.1
Individuals			8.7	5.6	6.5	7.8	11.6	7.6
Others			1.2	0.4	1.6	1.2	1.8	2.0
Earnings and profitability
	Return on assets		2.4	3.8	1.4	3.4	6.1	9.7
	Return on equity		50.1	43.1	18.7	62.7	121.6	125.8
Interest income to noninterest income			482.0	515.0	230.0	300.0	482.7	744.1
Net interest income to interest expenses			89.0	103.3	351.1	565.3	77.3	176.6
Personnel expenses to gross income			16.1	15.3	28.1	21.3	10.4	13.2
Liquidity
	Liquid assets to total assets		..	..	..	..	18.1	47.4
	Liquid assets to demand deposits		..	53.5	44.8	53.9	56.6	164.2
	Total (non-interbank) loans to customer deposits		..	..	..	..	74.1	65.0
FX deposits to total deposits			..	..	..	..	6.8	12.0
Sensitivity to market risk
Net open positions in FX to capital			..	..	..	..	-5.9	3.8
Memorandum Item
Inflation (end of period)			56.9	55.2	112.1	198.9	598.7	132.7

Source: RBZ

^1/Based on commercial banks only which account for about 80 percent of total banking sector assets.

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Table 3.

Zimbabwe Financial Soundness Indicators, 1999-2004

(In percent, unless otherwise indicated ^1/)

			1999	2000	2001	2002	2003	2004
Capital adequacy
	Capital to risk-weighted assets		15.3	18.3	22.4	16.2	15.0	34.4
		Tier 1 capital to risk-weighted assets	11.9	16.9	12.1	7.1	12.4	33.4
		Capital to total assets	6.0	9.5	10.4	8.0	7.5	12.1
Asset quality
NPLs to gross loans			14.1	18.2	13.7	7.9	4.2	23.2
Total provisions to NPLs			38.9	45.4	50.0	70.5	75.5	48.6
NPLs net of specific provisions to capital			48.2	45.5	35.7	10.1	14.9	38.2
	Loan concentration
Agriculture			15.8	14.5	12.8	11.2	10.9	21.4
Construction			1.5	4.3	1.9	2.3	3.1	2.2
Communication			1.6	0.7	3.0	1.3	0.7	2.5
Distribution			17.4	16.5	27.8	23.8	22.0	15.3
Finance & investments			3.1	12.1	10.8	5.0	1.7	0.4
Financial Organizations			2.7	7.4	1.6	6.8	2.1	0.3
Manufacturing			17.6	14.0	20.6	20.9	19.1	20.6
Mining			7.2	9.7	4.4	2.5	6.0	9.5
Services			19.9	11.3	6.7	14.0	18.7	15.1
Transportation			3.3	3.4	2.3	3.3	2.3	3.1
Individuals			8.7	5.6	6.5	7.8	11.6	7.6
Others			1.2	0.4	1.6	1.2	1.8	2.0
Earnings and profitability
	Return on assets		2.4	3.8	1.4	3.4	6.1	9.7
	Return on equity		50.1	43.1	18.7	62.7	121.6	125.8
Interest income to noninterest income			482.0	515.0	230.0	300.0	482.7	744.1
Net interest income to interest expenses			89.0	103.3	351.1	565.3	77.3	176.6
Personnel expenses to gross income			16.1	15.3	28.1	21.3	10.4	13.2
Liquidity
	Liquid assets to total assets		..	..	..	..	18.1	47.4
	Liquid assets to demand deposits		..	53.5	44.8	53.9	56.6	164.2
	Total (non-interbank) loans to customer deposits		..	..	..	..	74.1	65.0
FX deposits to total deposits			..	..	..	..	6.8	12.0
Sensitivity to market risk
Net open positions in FX to capital			..	..	..	..	-5.9	3.8
Memorandum Item
Inflation (end of period)			56.9	55.2	112.1	198.9	598.7	132.7

Source: RBZ

^1/Based on commercial banks only which account for about 80 percent of total banking sector assets.

109. The banking sector appears well-capitalized with a capital adequacy ratio (CAR) of 34 percent at end-2004 compared with 15 percent at end-2003. The considerable increase reflects increased retained earnings and capital injections to meet the higher minimum capital requirements introduced in January 2004 and the large holdings of zero-risk-weighted treasury bills. However, the reported figures need to be treated somewhat cautiously because despite the improvement in regulatory reporting, there may still be some under-provisioning, leading to the overstating of CARs. Reported CARs would decline if there were a significant shift in banks’ portfolios from zero-risk weighted government securities to loans to the private sector.

110. Liquidity ratios increased considerably and remained significantly above the prudential levels of 10 percent. These increased from 18.1 percent end-2003 to 47 percent of total assets at end-2004 largely reflecting the shift towards the short term investments in order to match the funding base as the public is increasingly investing short-term in response to continuing high inflation. A substantial proportion of short-term assets comprise government securities whose actual liquidity may be limited by the absence of secondary markets particularly in a time of distress.

111. The foreign exchange risk is minimal given the severe shortage of foreign exchange in the economy. Banking sector foreign currency denominated assets and liabilities estimated at 0.2 percent of total assets at end-March 2005 are negligible. Banks do not extend foreign currency loans, consequently there are no concerns about whether foreign currency borrowers are unhedged.

112. Stress testing indicates limited vulnerability to extreme but plausible shocks to the system (Box 2).⁶³ The stress testing considers only the direct effects of the shocks. In particular, the second-round effects of the interest rate increase and devaluation on asset quality are not considered. However, given the limited size of banks’ loan portfolio, the prevalence of subsidized credit, and the self-liquidating nature of many working capital loans, the second-round impacts would not be as significant as might otherwise be expected. In line with the key assumption that government securities are low-risk (Footnote 4), sovereign risk was not assessed. Sovereign default could trigger a banking crisis.

113. In addition, the risks to the banking system have been reduced through enhanced supervision leading to the exit of weak banks, and the improved approaches to corporate governance and risk management although these will take time to be fully effective. New prudential guidelines were issued in 2004 to establish minimum standards for corporate governance, internal audit, and the relationship between the supervisor and external auditors. These new guidelines have already had a substantial effect in the banking industry, with the reconstitution of the boards and/or senior management of a number of banks and while on-site examinations in 2004 did identify some progress within the banking sector in implementing these improved approaches, they will take time to be fully effective.

F. Deposit Insurance

114. The establishment of the Deposit Protection Board (DPB) in July 2003 was ill-timed given the absence of the basic pre-conditions for deposit insurance. This has been reflected in the minimal role played to date by the DPF in problem bank resolution. Nonetheless, its first premia were received in December 2003. It is chaired by the governor of the RBZ, and two deputy governors are also ex officio board members. The other three board members are appointed by the governor. This dominance of the DPB by the RBZ raises potential conflict of interest issues, as fiduciary responsibility to minimize costs to the DPB could, in some circumstances, conflict with RBZ objectives.

115. The DPB incorporates some elements of best practices, most notably compulsory membership for all licensed deposit-taking institutions to avoid adverse selection, and partial coverage to mitigate moral hazard. The insurance coverage was increased from Z$ 200,000 (about US$20) to Z$ 5 million (about US$500) in April 2005. Currently, a flat premium of 0.00738 percent of average deposits is applied to all financial institutions but the DPB is considering the merits of introducing a risk-adjusted premium in order to moderate the ‘subsidy’ provided by the strong to the weaker institutions. In practice, however, it is difficult to make an objective assessment of the size of the risk premium needed to have an impact on bank behavior.

116. The capital fund of the DPB is currently inadequate to meet insured depositors’ claims should a large bank fail. The relatively small size of the DPB largely reflects the fact that it is less than two years old. The DPB is empowered under section 68 of the banking act to borrow money for the purposes of the fund, and while there is no written agreement, the DPB believes that in time of need funds could be borrowed from the RBZ and/or government.

117. One of the challenges for the DPB is to keep its coverage meaningful in a high inflation environment while simultaneously ensuring the accumulation of an adequate fund. At end December-2004, the capital fund was worth Z$ 42 billion or 2 percent of total deposits of the largest bank. Although the capital fund increased to about 79 billion at end-May 2005, its exposure has increased significantly to about Z$ 246 billion given the higher coverage levels since April 2005.

118. The DPB’s current effectiveness is limited on two counts. First, the consensus in the financial industry is that customers have little or no awareness of deposit insurance, and thus the fund cannot perform its expected function of assisting smaller banks in competing against those banks perceived to be too big to fail. Second, even if consumers are aware, the rapid erosion through inflation of the real value of the insured limit, coupled with the current need for depositors to execute claims before a notary, can result in costs to the depositor of more than the value of the deposit. This view is substantiated by the failure of the majority of depositors to claim in the two institutions to date in which the DPB has been involved.

119. The DPB fund is a ‘paybox’ in the sense that it is only mandated to make payments to depositors of banks in liquidation. To date it has made payments to depositors of Century Discount House (Z$ 33.9 million representing 45 percent of total depositors) while ongoing payment is being made to Rapid Discount House (so far Z$ 64 million representing 30 percent of total depositors has been paid). The DPB should have the express legal capacity to make payments for transactions such as purchase and assumption agreements when these result in a lesser cost to the fund than paying depositors in liquidation.

120. The DPB plans a review of its legal framework, including amending the structure of the Board, and to allow DPB to participate in bank resolution and play a role as a liquidator. Further, it is expected that once the memorandum of understanding (MOU) between DPB and RBZ is operational, there will be increased information sharing and coordinated bank supervisory activities particularly in the case of problem banks. Further, its effectiveness will be enhanced by increased publicity.

G. Conclusions

121. Removal of weak banks from the system, strengthened supervision and improved governance has contributed to the enhanced resiliency of the Zimbabwe banking system. Most banks are coping surprisingly well with the difficult environment, although the ability to intermediate resources to support economic growth has been weakened. Further problems in the banking sector cannot be ruled out, but a continuation of current government policies is more likely to result in the slow wasting away of a still vibrant financial sector than it is to trigger a systemic crisis.

122. Three conclusions emerge from the foregoing analysis. First, the myriad of producer and credit subsidies which do not have a prudential foundation increase the administrative burden on borrowers and banks, and require greater policing activities by the RBZ, diverting scarce resources from more productive activities. Elimination of subsidized credit, introduction of a market determined exchange rate, and removal of restrictions without a prudential foundation would enable the banking system to more effectively intermediate to support economic growth.

123. Second, provision of full supervision powers to the RBZ has been crucial to the strengthening of the financial system through decisive action to remove weak institutions. The recent amendments to the banking act to require the RBZ to consult with the Minister of Finance on issues of licensing and intrusive supervisory action is a step backward. The RBZ should retain all supervisory powers, including licensing and the ability to intervene in weak institutions.

124. Third, it is important that erroneous conclusions not be drawn from the recent experience with curatorship, bridge banks and the use of public funds for bank resolution. The RBZ should instead develop contingency plans based on quicker intervention, faster resolution, and preservation of only the viable portions of failing banks, which will require a review of the deposit insurance scheme legal framework to allow the DPB to participate in bank resolutions such as purchase and assumption transactions. The true costs of the current approach have been obscured by high inflation, and depositors and other creditors would be better served through faster and less disruptive resolution of problem banks.