Private Sector Development in Low-Income Countries - Development in Practice (WB, 1996, 188 p.): Chapter 4-Building robust financial systems— difficult but pressing: What has been done?

Private Sector Development in Low-Income Countries - Development in Practice (WB, 1996, 188 p.)

(introduction...)

Foreword

Acknowledgments

Acronyms and abbreviations

Definitions and data notes

Overview

Chapter 1-From state to market uneven progress

(introduction...)

Recent policy reforms

Fast and slow growers

The drag of public

Regulation and barriers to competition a harsh business environment

Poor quality of physical infrastructure and human resources

The reform agenda

Chapter 2-Establishing an attractive business environment agile firms, agile institutions

(introduction...)

The private sector's assessment of the business environment

Foundations of a dynamic private sector

Secure, flexible transactions

Competition-and simplified regulation

Enterprise development

Efficient infrastructure

The agenda for developing an attractive yet competitive business environment

Chapter 3-Reforming public enterprise farther performing and faster

(introduction...)

Public enterprises are not performing well

Turning to the private sector—slowly

The way forward—farther and faster

Chapter 4-Building robust financial systems— difficult but pressing

(introduction...)

What went wrong?

What has been done?

What remains to be done?

The path for reform

Selected bibliography

What has been done?

During the past few years several low-income countries have begun the difficult and laborious task of reform. Economic stabilization has lowered budget deficits, reduced inflation, and restored trade by bringing the exchange rate toward market clearing levels. There has been important progress in financial sector policies, infrastructure, and institutions. And IDA has been quite active in supporting these reforms (box 4.1)

India, Pakistan, and Sri Lanka reduced state intervention in the financial sector, liberalized interest rates, removed credit ceilings, and allowed some entry by local and foreign banks—though still in a restricted fashion. These countries also restructured insolvent banks, privatized some banks, put into place prudential lending and capital adequacy guidelines accompanied by better supervision, and made major strides in developing their capital markets to attract or accommodate large inflows of foreign portfolio investment. New banks have entered the markets in India (box 4.2) and Pakistan to cater to the large increase in business activity, and total or partial privatizations of public banks are showing positive results.

Bangladesh also has liberalized interest rates and eliminated directed credit except for a small amount for export and small industry. But even with the denationalization of two banks and the entry of new local foreign banks, public sector banks account for 60 percent of the banking system, and nonperforming loans account for more than two-thirds of their assets.

In China, despite recent progress, the banking system remains highly segmented and fragmented. State banks, which still dominate the system, lend mostly to state-owned enterprises with a large portfolio of nonperforming assets at controlled interest rates. Rural and urban cooperatives, which are less controlled and regulated, lend to collectively owned enterprises. And foreign and joint venture banks service joint ventures and foreign firms. Prudential regulations are slowly replacing economic regulations, but information and skills are limited, and a major reform effort will be required to supervise the myriad financial institutions in this rapidly changing environment (box 4.3).

Sub-Saharan Africa has also made major reform efforts (table 4.1). By the end of 1993, interest rates had been freed (in 27 of the 34 Sub-Saharan countries), credit ceilings eliminated (in 23), directed credit reduced (in 27), prudential lending and capital adequacy guidelines introduced, with greater monitoring and enforcement powers for supervisory agencies (in 21), central banks strengthened (in 21), and money markets activated (in 15). New banking laws have been enacted to strengthen the banking system and protect users (for example, bank secrecy). Banks have also been recapitalized and restructured,

BOX 4.1 IDA INVOLVEMENT IN THE FINANCIAL SECTOR: BALANCING SYSTEMIC REFORM WITH FINANCIAL INTERMEDIATION LENDING

IDA has supported financial sector reforms designed to reduce financial repression, strengthen supervisory and regulatory frameworks, restructure and recapitalize distressed financial institutions, and increase competition and efficiency in the financial system. IDA has also been increasingly active in supporting the development of nonbank financial institutions and capital markets.

At the policy level, as part of an overall macroeconomic stabilization program, reforms have sought to liberalize interest rates, phase out sectoral allocation of credit, reduce implicit and explicit taxation on financial institutions, and phase in indirect monetary control procedures. Such measures have been important components of lending operations in countries such as Bangladesh, Cd'lvoire, Ghana, Kenya, Pakistan, Tanzania, and Uganda.

In such low-income countries as Bangladesh, Egypt, Ghana, Guinea Bissau, Malawi, Mauritius, Pakistan, and Uganda, lending operations in the financial sector have also focused on improving the supervisory and regulatory framework. Banking laws have been revised to strengthen supervisory and regulatory powers of central banks and introduce internationally acceptable prudential lending and capital adequacy standards. Technical assistance programs and twinning arrangements have been used to strengthen off-site and on-site supervicinn systems and to train hank examiners and supervisors, as well as to improve accounting and auditing capabilities.

At the financial intermediary level in such countries as Bangladesh, Cote d'Ivoire, Ghana, Kenya, Mauritania, Tanzania, and Uganda, financial and technical assistance has been provided for restructuring and recapitalizing financial institutions. In many instances, nonperforming loans of banks have been transferred to special debt collection and restructuring agencies and replaced by government obligations. Accompanying these measures have been privatization programs and reform of bank licensing policies that encourage entry by well-capitalized and reputable banks, legislation allowing entry and operations by nonbank financial institutions, reform of debt recovery procedures, and training programs for strengthening banking skills and know-how.

Between fiscal 1988 and 1995, IDA support for financial sector reforms amounted to about $3.9 billion. About 55 percent of the support was provided under Structural Adjustment Credits, and the balance was through Technical Assistance Projects and Financial Intermediation Credits that are being extended at market rates, in a competitive manner, and through qualified financial institutions that meet prudential capital adequacy ratios and lending criteria. Low-income countries in Africa accounted for about 65 percent of the adjustment operations.

BOX 4.2 LIBERALIZING INDIA'S FINANCIAL SECTOR

The sector. Publicly owned banks, comprising the State Bank Group and 19 banks nationalized in 1969 and 1980, dominate India's commercial banking system. Privately owned banks and branches of foreign banks account for a little more than 10 percent of assets (totaling about $110 billion) and deposits. Following nationalization, the government instructed publicly owned banks to pursue social and developmental goals. During the 1 970s and 1 980s, these activities—combined with high operating costs, obsolescent technology (bank labor unions opposed computerization), interest controls, high reserve requirements, directed credit, forced investments in government securities, and loan forgiveness—eroded the effectiveness and performance of these institutions.

India has four "All-lndia" developmental lending institutions, three of which are majority-owned by the government (with about $17 billion in assets), and several other development institutions specialized for such sectors as agriculture, small industry, and housing. There also are more than 30,000 nonbank financial institutions, most privately owned, and a large number of credit cooperatives. India has one of the world's largest capital markets, featuring capitalization exceeding $100 billion and more than 6,000 listed companies.

Reforming the banks. Indian commercial banking is now undergoing thorough reform. Policy changes since 1991 have included the introduction of tighter asset classification, income recognition, and disclosure norms. Reserve requirements and forced investments are being scaled back. And interest rates are being rationalized and liberalized. The minimum lending rate was removed in October 1994, and the government plans eventually to remove a deposit rate ceiling (currently above market levels).

The government hopes to transform the publicly owned banks from bureaucratic entities into vigorous commercial enterprises. These institutions are now engaged in far-reaching reform, including recapitalization, the introduction of modern computer based technology, organizational streamlining, and the recovery of nonperforming loans. Over the next few years, the government intends to increase nongovernment equity in the banks to as much as 49 percent (of total equity) and to increase private sector representation on bank boards accordingly.

To improve competition, the Reserve Bank of India (RBI) has authorized several new, wellcapitalized private banks and branches of some foreign banks to enter the market, although it continues to restrict entry generally. A functionally autonomous Board of Financial Supervision was established in late 1994 within the RBI, now responsible for commercial banks, development finance institutions, and nonbank financial institutions. The RBI now has a program to upgrade its supervision capabilities.

Public securities markets. The RBI has begun to develop and deepen India's markets for public securities. This should enable India's various governmental entities to meet their financing needs more efficiently. For the past two years, the RBI has steadily increased its reliance on open market operations rather than direct controls for monetary management. Under a 1994 RBI-Finance Ministry accord, the Treasury's access to direct RBI financing is to be phased out.

Strengthening capital markets. Liberalized regulation has improved the functioning of India's capital markets. In 1992, the Controller of Capital Issues, which set the pricing of new equity issues, was abolished. The Securities and Exchange Board (SEBI), established in 1 988, now reviews the pricing of initial share offerings. The SEBI has acted vigorously to modernize outmoded practices in India's equity markets but has generally set a more liberal approach to market regulation. Twenty-two new private sector mutual funds now compete with funds offered by the government-owned Unit Trust of India. Overseas investors have placed a large volume of funds in India's equity markets since they were liberalized in late 1992. Equity trading has strained the capacity of the existing transactions and custody system, and the authorities have acted rapidly to help ease regulations and practices designed for a smaller system.

BOX 4.3 CHINA: THE MAKING OF A FINANCIAL SYSTEM

The development of China's financial sector has lagged behind that of its fast-growing real sector. Until fairly recently the financial sector consisted only of four specialized banks (the Agricultural Bank, the Bank of China, the Industry and Commercial Bank, and the People's Construction Bank). Today a vast network of rural and urban cooperatives and several hundred nonbank financial intermediaries—trust and investment companies, finance companies, leasing companies, and security corporations—compete with these state banks. Shanghai and Shenzhen have had stock exchanges since 1990, and stock markets are now flourishing in scores of Chinese cities.

Low inflation throughout the 1980s and moderate interest rates (which on average provided savers with zero or positive real returns) stimulated resource mobilization. But with increasing inflation during the past few years, real interest rates on deposits and loans from state banks have turned negative. This has contributed to the rise of smaller, unregulated intermediaries, which are less subject to control and are sometimes owned by the larger banks, to service the township and village enterprises and private companies. In many cases, collective and private enterprises are paying relatively high rates of interest to offset the low rates paid by the state enterprises. Large deposits now flow between the formal and informal system depending on the changing relationship between savings and credit interest rates.

Despite efforts to strengthen the central bank—the People's Bank of China (PBC)—prudential regulation and supervision is still embryonic, particularly for specialized banks and small intermediaries that finance collective and private enterprises alike. The decentralization of government under way in China means that control of many state-owned enterprises, which account for 45 percent of China's output, has been transferred to local governments, which influence provincial branches of the PBC. Although one-third to one-half of all large and medium-size state-owned enterprises run at a loss, provincial branches of the PBC have enabled them to fund large investments, which accounts for the fact that large nonperforming loans are now estimated to account for 15-20 percent of China's bank assets.

To strengthen the country's segmented financial system, the government is considering a new central banking law under which the PBC would be charged with carrying out an independent monetary policy to maintain a stable value of the currency. replacing direct instruments (such as credit plans) by indirect ones (such as interest rates and openmarket operations), transforming the four big specialized banks obligated to finance state-owned enterprises into commercial banks, and setting up three additional banks for infrastructure, agriculture, and international trade to take over the responsibility for policy lending. The PBC would be overseen by the proposed state monetary policy committee, which would be chaired by the PBC governor and include several cabinet ministers.

The World Bank has supported China's efforts to develop its financial sector since the late 1 980s. Specialized institutions were equipped to appraise borrowers and manage international loans (such as projects sponsored by the Bank together with the China Investment Bank). Major programs currently being implemented or designed include components to:

· Advise on major policy issues (interest rate policies, directed credit, financial sector legislation, and prudential regulations).

· Help develop monetary policy instruments and practices.

· Design and automate a nationwide payment system.

· Develop supervisory, regulatory, research, and fiscal agent skills within the central bank.

· Train bank staff in accounting and audit standards and functions.

· Develop rules needed to regulate capital markets.

TABLE 4.1 BANK REFORMERS IN SUB-SAHARAN AFRICA

Liberalization and/or rationalization of interest rates	Restructuring of banks	Privatization of banks	Liquidation of banks
Benin	Cameroon	Cameroon	Benin
Burundi	Cd'Ivoire	Cd'lvoire	Cd'lvoire
Congo	Ghana	Guinea-Bissau	Guinea
Cd'Ivoire	Guinea	Madagascar	Niger
The Gambia	Kenya	Mauritania	Rwanda
Ghana	Madagascar	Senegal	Senegal
Kenya	Mali
Madagascar	Mauritania
Malawi	Rwanda
Mauritania	Senegal
Mozambique	Tanzania
Rwanda	Uganda

Note: This table does not comprehensively list all the financial sector reforms undertaken.
Source: World sank 1994.

Liquidated, or privatized in about 25 countries (table 4.2). The number of government owned and controlled banks was reduced from 140 in the late 1980s to about 115 in 1993. During the same period, the number of private banks rose from 80 to 115, and their share in the assets of the banking system increased from 30 percent to more than 40 percent.

Despite these major improvements, important structural weaknesses remain in lowincome countries. Banks continue to finance central government deficits and overextended and uneconomical public enterprises. Typically, about 40 percent of domestic credit (and sometimes as much as 80 percent) goes to the public sector. Credit in the private sector—when it is not crowded out— is garnered by large and politically well-connected firms and traders. Most farmers and small and medium-size indigenous firms have little access to credit, and their growth is limited to what they can finance from retained earnings.

Government-owned or controlled banks still dominate in many lowincome countries. In Sub-Saharan countries, they account for more than half the banking system. In most cases, they have weak management, limited bank ing skills, and ineffective internal controls, and their balance sheets do not reflect their precarious financial position. Credit evaluation of state enterprises is virtually nonexistent because the public banks generally allocate credit following directives from the government—despite the official elimination of directed credit. These loans have the explicit or implicit backing of the government, so banks seldom evaluate the creditworthiness of public sector borrowers.

TABLE 4.2 PROGRESS IN THE FINANCIAL SECTOR IN SUB-SAHARAN AFRICA

Notable progress	Progress	Slight progress	Regressing or repressed financial system
Botswana	Benin	Burkina Faso	Burundi
The Gambia	Cd'lvoire	Gabon	Cameroon
Lesotho	Eritrea	Guinea	Central African Republic
Mauritius	Ghana	Guinea-Bissau	Chad
Uganda	Madagascar	Kenya	Congo
	Malawi	Mali	Ethiopia
	Mauritania	Sierra Leone	Mozambique
	Namibia	Swaziland	Niger
	Senegal	Zambia	Nigeria
		Zimbabwe	Tanzania
			Togo

Influential private firms often continue to borrow without adequate scrutiny from either affiliated private banks or public banks. Prudential regulation and supervision remain inadequate, and bank insolvency is not quickly detected. Even when it is detected, governments often are reluctant to close banks because of the adverse impact on economic activity and because they are financially unable to meet calls on explicitly or implicitly insured deposits.

Governments in many countries continue to restructure problem banks by periodically swapping nonperforming loans with government and central bank obligations. But bank recapitalization alone is ineffective because it has to be repeated if the underlying causes are not addressed. The costs have been enormous: typically 7-10 percent of GDP spread over four to ten years. With the government absorbing these losses, there naturally is the expectation that it will do so again, leading to continued losses by poorly supervised banks. So crises recur, as in Mauritania and particularly Tanzania, where public sector bank recapitalization in 1991 is estimated to have cost about 20 percent of GDP. Despite this costly recapitalization, 70 percent of the assets of the National Bank of Commerce, the main public sector bank with 82 percent of the system's assets, are nonperforming; and a serious collection effort has yet to start.

Governments typically finance these large losses by issuing bonds, and interest on the bonds affects the budget for years to come, at an annual cost often equal to total government spending on health. Add to these interest costs direct government expenditures on public enterprises (5-7 percent of GDP) and treasury obligations to service public enterprise debts, and the burden of public enterprises (as noted in chapter 3) rockets to a staggering 8-12 percent of GDP.

The point is that a large part of these losses is hidden in the banking system—exposed only periodically when a banking crisis threatens. Then, governments often resort to a bout of inflation, possibly adding to economic uncertainty and dampening savings, private investment, and growth. The burden is particularly harsh for small-scale farmers and entrepreneurs denied credit. Unless the dominant position of public enterprises is reduced and their privileged access to bank credit is stopped, economic stability is threatened— and the banking system faces ruin.