Working Paper 174 - African Development Finance Institutions: Unlocking the Potential
Categories: Economic & Financial Governance
Africa escaped the recent global financial crisis relatively unscathed. While the region could not avoid the spill-over effects of the ensuing global economic downturn, its banking sector proved generally resilient. This was mainly due to the structural reforms implemented over the past decade, including strengthening the relevant regulatory and supervisory systems within a sounder and more flexible macroeconomic management framework. In particular, Basel III offers a set of regulatory standards based on higher and better quality capital, mostly common equity, with improved absorption features, complemented by newly introduced liquidity requirements. This paper provides the first analysis into the macroeconomic impact of the new international regulatory standards on developing countries, particularly on African economies.
The paper tries to answer the following set of questions: what is the impact of tighter capital ratios on long-term economic performance in Africa? Is there still room to raise capital holdings from current levels while achieving net aggregate economic gains? In particular, this paper presents an assessment of the long-term economic benefits and costs of higher capital ratios in terms of their impact on output. Additionally, the paper provides an estimate of the optimal level of regulatory capital requirements for African banking systems. Consistently with other studies, the focus is on the macroeconomic impact of representative changes in bank capital adequacy ratios based on definitions and historical data that do not correspond directly to those introduced by Basel III. The paper focuses exclusively on the long run, assessing the shift from one steady state to another, and does not consider the shorter-term costs associated with the transition.
The paper estimates the long-term macroeconomic impact of higher capital holdings on output in African economies by following a three-step approach. First, the long-term benefits are estimated by quantifying the gains in African GDP resulting from a reduced probability of future banking crises. This involves calculating the expected yearly output gains associated with a reduction in the frequency of banking crises in the continent. The mapping of tighter capital ratios into reductions in the probability of banking crises is done based on a multivariate logit model for a panel of 19 countries for which data are available over the period 1980-2008.
Second, the long-run economic costs of higher capital ratios on output are evaluated by estimating the impact on the cost of bank credit. The higher cost of credit lowers investment and consumption, which in turn affects the steady-state level of output. Two panel data for 22 countries over the period 2001-2008 are used to quantify this. Finally, the study combines the results to quantify the net effect of higher capital ratios on aggregate output of African economies.
The paper shows that tighter capital ratios have net positive effects on the level of long-run steady-state output for a relatively wide range of capital levels. There are increasing net benefits for capital ratios up to four percentage points higher than the current level. Thereafter, net benefits start decreasing and, for increases in the current capital ratio of more than nine percentage points, the marginal net benefits of higher capitalization turn negative. Given that African banking systems hold on average capital buffers in excess of minimum requirements, African regulators should ensure that banks keep current levels of capitalization at a minimum. One option to influence bank behaviour would be to raise capital requirements so as to provide a regulatory floor under current capital ratios. In this context, Basel III offers an important opportunity to strengthen the resilience of African banking systems.