Selected Issues

Abstract

Selected Issues

Financial Sector Risks and Monetary Policy Effectiveness1

This note updates and extends previous work on financial sector risks in Comoros (see IMF Country Report 16/394 – Selected Issues). It analyzes the key contours of financial sector risk in Comoros, also vis-à-vis comparators in Sub – Saharan Africa (SSA), and how these have shifted since the last analysis. The overall picture of financial health is mixed. Comorian banks remained well – capitalized and liquid since end-2015, while provisioning slipped, NPLs persisted at elevated levels, and aggregate profitability remained stagnant. These features are also borne out by the cross-country comparison with comparators in Sub-Saharan Africa. But the financial health outlook is heterogeneous across institutions, with large NPL portfolios well provisioned-for and concentrated in less systemically-important institutions, interbank linkages that are small in economic size and limit potential financial system contagion, and variable profitability across institutions. Implications of financial sector fragility for the effectiveness of monetary policy are also explored and recommendations for improving policy effectiveness are developed.

A. Background and Macroeconomic Context

1. Comoros faced continued macroeconomic challenges in 2017 (Figure 1). Largely on the back of an improved electricity supply throughout the year and favorable external sector developments, growth in 2017 increased moderately to 2.7 percent. Inflation dipped to 1 percent on average for the year, chiefly reflecting lower import prices. Fiscal policy execution remained challenging, particularly with stagnant tax revenues that fell well short of the authorities’ ambitious budgetary targets.

Figure 1.
Figure 1.

Macroeconomic Developments

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Sources: country authorities; and IMF Staff calculations.

2. Comoros’ macroeconomic challenges also impacted upon the financial sector (Figure 2). In the face of the above macroeconomic headwinds, the downward trend in private sector credit growth of recent years continued in 2017. This was due in the main to the sustained elevated level of NPLs and the associated difficulties in recovering doubtful loans, which increased financial institutions’ lending risk. Meanwhile, the government borrowed from a financial institution (KMF 3bn / about 1 percent of GDP) to help finance its expenditure needs. Also, deposit growth faltered, after strong expansions in the deposit base in previous years associated with one-off factors (budget support, telecommunications license payment), while isolated liquidity tensions emerged amidst some governance problems.

Figure 2.
Figure 2.

Financial Sector Developments

(Percent)

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

3. Against this backdrop, this paper analyses three key issues. First, the key risk features of the Comorian financial sector and their changes over time are analyzed, also within an SSA context. Second, a preliminary empirical analysis explores the implications of financial sector fragility and risks in Comoros for monetary policy effectiveness. Third, recommendations for improving financial sector health and the efficacy of monetary policy in Comoros are developed.

B. Stylized Facts—Financial Sector Fragility and Risks

4. The Comorian financial system is mildly concentrated and composed of eight deposit-taking and lending institutions, including microfinance networks and foreign-owned banks. The activities of the four commercial banks operating in Comoros are complimented by three microfinance institutions, as well as by the systemically-important (about one-fifth of system-wide deposits) state-owned postal bank (SNPSF). Microfinance institutions are particularly prominent in rural areas and on the smaller islands (Anjouan, Mohéli). The three largest financial institutions control 60 percent of system-wide assets. At present, three banks are foreign-owned, although the ownership structure of the sector is currently in flux.

5. Most financial institutions engage in traditional banking activities, are subject to the same prudential requirements, and with one exception to the same taxation laws. Two banks and one microfinance institution accept only gold as collateral. Illustrating collateral quality problems in the economy, the microfinance institution that only lends against gold experienced the joint-fastest loan book growth in 2017. With one exception – a microfinance network that is the most profitable financial institution in the country – all financial institutions make significant tax contributions to the state coffers (0.8 percent of total tax revenues in 2017).

6. Responsibility for financial sector supervision lies with the BCC, supported also by technical assistance from the Fund and other partners, although the Ministry of Finance has some influence on system regulation. The financial sector surveillance unit (DSBR) of the BCC is responsible for financial sector supervision and enforcement of prudential norms and regulations. The supervisor closely monitors financial sector institutions through and intensive program of on-site and off-site inspections, also sanctioning institutions when they are found to be in violation of prudential regulations. The DSBR also continues to benefit from an extensive program of Fund-supported technical assistance, particularly regarding risk-based supervision, receiving also assistance from the French prudential regulator (ACP). The Ministry of Finance has a limited influence on the financial system, through the administration of interest rates (see below) and directions given to state-owned enterprises about where to place deposits.

7. An examination of changes in financial soundness indicators since the last exercise presents a mixed picture (Figure 3, upper panel). Comorian financial institutions remained well-capitalized and liquid over the period 2015 – 2017. But provisioning decreased and NPLs remained high at almost a quarter of the total loan portfolio. This, combined with a slippage in the rate of provisioning, left the balance sheet exposed to an NPL write-down.2 Profitability remained stagnant.

Figure 3.
Figure 3.

Selected Financial Soundness Indicators

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Note: the direction that indicates and imporvement in each individual FSI ration is indicated with a (+) ot (−) for each ratio.Sources: country authorities; and IMF Staff calculations.

8. The health of the Comorian financial sector is heterogeneous across financial institutions (Figure 3, lower panel and Table 1). The spread of financial soundness indicators around the sector-wide indicator is noticeable, reflecting the differing degree of financial health between institutions. Some fare relatively poorly on as few as 2 or 3 indicators, whilst others are experiencing issues in multiple areas.

Table 1.
Table 1.

Comoros: FSI Heatmap 2017

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Source: BCC and IMF Staff preliminary calculations.Note: Heatmap thresholds are the median indicator across all institutions, calculated by the desk on the basis of balance sheet data provided by the authorities. Green indicates that an institution is above (+) or below (-) the threshold.

9. Exposure to unprovisioned NPLs is an ongoing concern, but heterogeneity matters (Figure 4). Measured on a sector-wide basis, unprovisioned NPLs rose compared to previous years. A more granular analysis reveals that smaller financial institutions (measured by assets / total assets) tend to have larger non-performing loan portfolios. One exception is a systemically-important institution (about one-fifth of system-wide assets), one-third of whose loan book is non-performing. Fortunately, provisioning rates in the institutions with larger NPL portfolios tend to be higher.

Figure 4.
Figure 4.

Non-Performing Loans and Provisions

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Sources: BCC; and IMF staff calculations.

10. Comoros’ persistently high NPL stock reflects two main factors. First, it includes a considerable proportion of legacy loans that turned sour during the vanilla sector crisis of the early 2000s and remain unresolved, along with other bad loans that are yet to be written-off by holding institutions. Second, a few well-connected debtors in Comoros’ undiversified economic structure account for the vast proportion of the NPL stock. Recovery of these doubtful loans is particularly difficult in the absence of both specialized financial courts and rigorous enforcement of judicial decisions. Nevertheless, the authorities expect that a regulation that mandates the better classification, provisioning and write-off of loans, with a compliance date of end-2018, will see the NPL ratio drop considerably by this date, particularly with resolution of legacy vanilla sector loans. There is no concrete evidence that feedback effects to NPLs from government arrears to domestic suppliers are a major factor in Comoros.3

11. Lending continued to non-productive economic sectors in 2017, with new NPLs reflecting this trend (Figure 5). As in 2015, commerce and households continued to be the two economic sectors to which the greatest proportion of new credit was extended in 2017. New NPLS in 2017 also followed this pattern. These trends reflect the lack of bankable projects in Comoros outside of the import business.

Figure 5.
Figure 5.

Lending and Non-Performing Loans by Industry Category

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Sources: BCC and IMF Staff calculations.

12. In the Comorian financial system, inter – institution linkages are limited and small in economic size, but two banks hold significant proportions of total inter-institution deposit holdings. Commercial banks hold deposits of other resident commercial banks and microfinance institutions, while microfinance institutions themselves hold neither. Reflecting the underdeveloped nature of the Comorian financial system, total inter - institution deposits only amount to about 1.5 percent of GDP. However, these deposits are highly concentrated, with two banks together holding over 90 percent of deposits from other banks, and over 65 percent of deposits from microfinance institutions.

13. The limited nature of inter-institution linkages means that the difficulties of the systemically-important SNPSF and the associated fiscal risks to the State’s balance sheet persist, although 2017 saw the welcome first steps in implementing the authorities’ recovery plan for the institution. SNPSF, which offers both traditional banking and postal activities, is solely-owned by the State, which is therefore obliged to backstop the institution in tough times. Despite that SNPSF has faced major operational difficulties for many years, it continues to attract about one-fifth of system-wide deposits (chiefly civil servant salaries and SOE deposits). The latest-available estimates indicate that to make SNPSF fully-functional, an injection of about KMF 10.4bn / 3.7 percent of GDP / 22 percent of government revenues would be needed.4 In 2017, the authorities implemented the first tranche of their three-year rescue plan, using funds from the BCC statutory advance facility. Whilst further adequate funding for the rescue plan is still to be identified, limited financial sector linkages would limit the possible contagion of any financial stress it may experience in the meantime.

14. A cross-country analysis reveals that the relatively well-capitalized and liquid Comorian financial sector is however in some respects more fragile than that of comparator countries (Figure 6). The financial sector in Comoros is well-capitalized and highly liquid, compared to the peer group average in Sub-Saharan Africa (SSA).5 However, the loan portfolio is of relatively poor quality, and the sector is relatively more-exposed to unprovisioned non-performing loans. Aggregate profitability, measured by both return on assets (ROA) and return on equity (ROE), is much lower than in comparator countries, but in Comoros this result appears to be chiefly driven by two outlier institutions.

Figure 6.
Figure 6.
Figure 6.

Cross-Country Comparison of Selected Financial Soundness Indicators 2016

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Sources: Country authorities, IMF Staff Calculations.Note: PRGT-eligible countries included are Burundi, Cameroon, CAR, Chad, Ghana, Guinea, Kenya, Lesotho, Madagascar, Rwanda, Uganda, Zambia.

C. Financial Sector Health and Monetary Policy

15. How effective are monetary policy tools in the context of the above-described macro-financial developments and financial sector fragilities? As noted above, credit growth has slowed in recent years, while excess liquidity has persisted. To what extent are the available monetary policy tools useful in the context of high NPLs, and what is the impact of monetary policy on credit to the economy hence economic growth in this context?

16. In the context of the monetary cooperation agreement with France that regulates country’s fixed exchange rate with the Euro, the Central Bank of the Comoros (BCC) possesses two main monetary policy tools. These are (i) the level of statutory reserve requirements, and (ii) the remuneration on obligatory and excess financial institution deposits.6 Since January 2014, the statutory reserve requirement has been fixed at 15 percent of financial institution deposits (versus 20 percent before this date). The interest rates available on statutory and excess reserves are both linked to the Eurozone Overnight Index Average (EONIA). The interest rate on obligatory reserves is calculated by the formula EONIA – 1.25 percent, and EONIA – 0.125 percent for the remuneration on excess reserves. Due to the very low level of Eurozone interest rates in recent years, the BCC decided to apply a zero rate to statutory and obligatory reserves when the adjusted EONIA rate results in a negative interest rate. This has been the case since August 2012.

17. The administered corridor for financial institution lending to the private sector is significantly higher than the zero-remuneration available on financial institution deposits at the central bank. The Ministry of Finance, on the advice of the BCC, has set the lending rate corridor between a minimum 7 and a cap of14 percent. Deposit rates at financial institutions are also administered, with a floor of 1.75 percent.7

18. A variety of factors, chiefly lender risk aversion, limited economic diversification and a shortage of bankable projects, restricted investment opportunities in the context of an underveloped financial system, as well as foreign exchange flows, contribute to excess liquidity in Comoros. Despite the significant spread available through lending to the private sector, financial institutions prefer to hold unremunerated deposits at the BCC that are well in excess of the statutory requirement, rather than lend these funds. Financial institutions thereby eschew high potential returns from lending to the private sector, preferring to remain prudent and reticent to lend. Anecdotal evidence suggests that in the face of poor collateral, risk aversion is so high that this would be the case even if lending rates were substantially higher than the mandated 14 percent ceiling. Furthermore, a shortage of bankable projects in the undiversified private sector, as well as underdeveloped financial markets leave banks with few alternative investment opportunities. These factors, along with foreign currency flows (for example significant inbound remittance flows), contribute to structural excess liquidity that has been at least equal to, and often greater than (expressed as a percentage of GDP), the magnitude of required reserves (Figure 7). This structural excess liquidity weakens the monetary policy transmission mechanism and the ability of BCC to influence demand in the economy.

Figure 7.
Figure 7.

Financial System and Interest Rates

Citation: IMF Staff Country Reports 2018, 190; 10.5089/9781484363775.002.A004

Sources: country authorities; and IMF staff calculations.

19. In Comoros, sterilization tools – the usual policy approach for managing excess liquidity – are in the developmental phase, but it is unlikely that these will address the structural issues underlying the phenomenon. The BCC plans to introduce central bank bills in July 2018 to manage structural excess liquidity (see Selected Issues chapter on Modernizing the Monetary Policy Framework). Apart from the potential costs of sterilization (effect on central bank income, weakening of the central bank balance sheet, these tools are unlikely to address the poor quality of bank balance sheets and the associated lender risk aversion, which are a major contributor to structural excess liquidity in Comoros.

20. Preliminary empirical analysis suggests that monetary policy effectiveness in influencing credit growth depends on the quality of bank balance sheets, highlighting the effects of lender risk aversion on financial institution credit provision. An empirical model is used to analyze the strength of the relationship between the (lagged) BCC policy rate and credit to the private sector depending on the level of loan provisioning (used as a proxy for balance sheet quality).8 Results show that during the period prior to August 2012 (when the BCC policy rate was positive), the strength of the negative association between the (lagged) BCC policy rate and credit to the private sector (controlling for the $US / KMF exchange rate and a time trend) in the case of high-quality balance sheets (low provisioning was about six times as strong than in the case of high loan provisioning. After August 2012, the estimated trend in private sector credit is lower in the high provisioning case, than in the low-provisioning case. These results highlight that above a certain threshold, lender risk aversion is so high (due to difficulties in recovering doubtful loans) that financial institutions are reluctant to lend to the private sector. Instead, they prefer to park their funds with the central bank and receive zero interest, contributing to structural excess liquidity.

D. Conclusions and Policy Recommendations

21. The above analysis shows that while the Comorian financial system suffers from some persistent vulnerabilities, there are some ameliorating factors. The persistently high NPL level and provisioning levels are worrisome, while faltering deposit growth, ongoing governance issues and isolated liquidity tensions demonstrate that the financial system operates under continued duress. On the positive side however, the sector remains broadly well-capitalized and liquid and, with large NPL portfolios confined to less systemically important financial institutions, interbank linkages that are small in economic size, and profitability that at a more granular level is not as stagnant as aggregate indicators would suggest.

22. Financial sector weaknesses hamper monetary policy effectiveness in the context of structural excess liquidity. In particular, low-quality loan portfolios heighten lender risk aversion and reduce financial institutions’ willingness to lend. This, combined with a shortage of bankable private-sector projects and underdeveloped financial markets induces structural excess liquidity and weakens the transmission mechanism between monetary policy and private sector credit.

23. To address financial sector fragilities, the BCC should continue to closely monitor financial institutions to address any further emerging problems. Rigorously implementing a regulation that provides for the better classification of, provisioning for, and write-off of loans by end-2018 should reduce the NPL level to a more-acceptable level (assuming that more loans are not reclassified as doubtful in the process of applying the regulation). This is because most of the legacy NPLs from the vanilla sector, along with other NPLs, will likely have been written-off by this time. In the meantime, the authorities should continue to closely monitor financial institutions to ensure that liquidity tensions do not reemerge.

24. Improving monetary policy effectiveness and encouraging private sector lending will require a more comprehensive policy approach involving all stakeholders. The BCC plans to convene a meeting of all relevant stakeholders (Ministry of Finance, BCC, private sector, banks) in order to find an integrated solution to the question of boosting financing to the economy. An essential component of such an integrated strategy is an effort to address structural excess liquidity through reducing lender risk aversion. This could for example be achieved through improving the quality of lending collateral and guarantees, as well as enhancing the prospects of loan recoverability in the context of a more effective judicial system. However, better judicial decision enforcement will not be easy in the Comorian context of a small island state with tight-knit social relations. Implementing central bank bills, while a welcome step towards enhance financial sector development, should be considered as a liquidity management tool, rather than as addressing the root cause of structural excess liquidity (see Selected Issues chapter on Modernizing the Monetary Policy Framework for further details).

Annex. Interest Rates in the Comorian Economy

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1

Prepared by Ibrahim Ahamada, Michel Bua, and Cameron McLoughlin, with excellent support from Mounir Bari. The chapter benefited from extensive comments from the BCC and several IMF colleagues.

2

A write-off of all unprovisioned NPLs would consume about half of system-wide capital.

3

The latest data on government arrears to the private sector date from June 2013 and are not available by sector.

4

This figure may be higher once an ongoing accounting audit of the institution’s books is completed. The audit had an original target deadline of 20th April, which has since been surpassed.

5

The peer group comprises PRGT-eligible countries in SSA for which data are available (Burundi, Cameroon, Central African Republic, Chad, Comoros, Republic of Congo, Ghana, Guinea, Kenya, Lesotho, Madagascar, Rwanda, Uganda and Zambia).

6

The BCC has other interest rates (e.g. the discount rate, calculated at EONIA + 1.5 percent), but which are less operational (e.g. due to lower interbank financing needs in a situation of structural excess liquidity).

7

See Annex for a summary of interest rates applied in the Comorian economy.

8

The same results obtain when using NPLs as the threshold variable upon which the strength of the relationship between the BCC policy rate and credit depends, albeit with fewer available observations. Two lags of the policy rate variable are used in the model to avoid endogeneity concerns.

Union of the Comoros: Selected Issues
Author: International Monetary Fund. African Dept.