Financial Sector Development in African Countries: Major Policy Making Issues 3030329372, 9783030329372

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Financial Sector Development in African Countries Major Policy Making Issues

Omotunde E. G. Johnson

Financial Sector Development in African Countries

Omotunde E. G. Johnson

Financial Sector Development in African Countries Major Policy Making Issues

Omotunde E. G. Johnson International Monetary Fund Retiree Independent Researcher McLean, VA, USA

ISBN 978-3-030-32937-2    ISBN 978-3-030-32938-9 (eBook) https://doi.org/10.1007/978-3-030-32938-9 © The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer Nature Switzerland AG 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover illustration: Pattern © Harvey Loake Cover design: Calamar Studio This Palgrave Pivot imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

Finance and the financial system are extremely important for economic development and growth as well as per capita income and income distribution of a country. Hence, a country benefits from sound policies to improve the state and effectiveness of its financial system to promote economic development and growth and help reduce poverty and income inequality. Financial sector policies typically include structural reforms of the system as a whole, refinements of particular financial instruments, adjustments of the supervisory and regulatory systems, and introduction of policy instruments that directly address particular social concerns, most notably financial inclusion. This book addresses major challenges in financial sector policymaking and implementation that are of current relevance to African countries. Chapter 1 is a brief overview of the main issues covered in the rest of this book. Chapter 2 focuses on the core elements of financial sector development as a whole, highlighting major areas such as the money market, payment system, and the capital market, as well as issues such as regulatory strategy, capacity building of financial firms and service providers, and financial inclusion. This book then turns, in Chap. 3, to foreign exchange market issues, with which many of the African countries are struggling, for reasons including the importance of the strength and convertibility of their currencies, imports and exports, as well as capital flows, for their economic development. In this context, most of the countries prefer high degree of stability of their exchange rates. This book argues that African countries should aim for social efficiency of their foreign exchange markets, which would include soundness of their foreign exchange systems, v

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from an economic growth perspective, and fairness from an income distributional perspective. Finally, some of the African countries would like to have financial systems that are strong enough to be international financial centers of high-standing. This book, in Chap. 4, discusses the policy implications of such an ambition. In particular, a policy strategy for developing such a financial center will include conceptualizing a financial center as a cluster; finding a niche for entry at the international level, in terms of clientele, products and appropriate service provisions; enhancing competitiveness by building capacity, structuring incentives, and improving the quality of the national governance environment; and having in place high quality financial services supervision and regulation. Financial sector development can occur in the context of spontaneous order. The premise of this book is that coherent policymaking and implementation can speed up that process, applying directly knowledge gained from relevant economic theory and analytical framework, historical experience, and various empirical evidence. In this light, this book discusses coherent financial sector development policymaking and implementation by country authorities. Important aspects of the process would be getting the fundamentals right; designing sound governance structures, including appropriate regulatory and supervisory systems and standards; and focusing directly on major areas such as money market development, payment system development, capital market development, financial inclusion, and insurance. This book argues that in the context of promoting a socially efficient foreign exchange system, the policymakers of the government and the central bank should agree on a macroeconomic policy framework and the central bank should develop a governance structure for the forex market, with monitoring rules and enforcement mechanisms, to ensure sound operations of the foreign exchange system as a whole. The central bank in its intervention in the forex market should not distort the openness and fairness of private foreign exchange market operations. Interventions by the central bank in the foreign exchange market can succeed in smoothing the path of the exchange rate and in stabilizing (not fixing) the rate, both of which may be of value to the welfare of the citizens under certain circumstances. If an African country has a fairly well-developed financial system, and a socially efficient foreign exchange market, achieving the status of a sound international financial center could be well within its reach, if it chooses to build one, irrespective of the economic size of the country in terms of

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gross domestic product. The geographical area in which an international financial center is located must be attractive as a place where people want to live, work, and visit. A policy strategy for developing a financial center will involve conceptualizing the center as a cluster; finding a niche for entry at the international level, in terms of clientele, products and appropriate service providers; enhancing competitiveness by building capacity, structuring incentives, and improving the quality of the national governance environment; and putting in place high quality financial services supervision and regulation. The capacity of the financial center will be built by strengthening the institutions (rules governing behavior), organizations and mechanisms in the host country to support innovation in financial services; by investing in appropriate human capital; by raising financial capability of citizens; and by putting in place appropriate physical and technological infrastructure. Keeping taxation at low rates will also be helpful. Selective intervention policies to promote the center can include assisting with market research and information on new products and knowledge inputs; making available critical infrastructure and public services at competitive costs to users; and making a special effort to patronize the center especially via demand for its services. McLean, VA

Omotunde E. G. Johnson

Contents

1 Introduction  1 2 Getting the Basics Right  9 3 Establishing Socially Efficient Foreign Exchange Markets 79 4 Attaining Sound International Financial Center Status103 Index 139

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List of Tables

Table 2.1 Table 4.1

Table of African stock exchanges Selected global financial centers, 2018—top 60

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CHAPTER 1

Introduction

Abstract  This book addresses major challenges in financial sector policymaking and implementation that are of current relevance to African countries. It begins with a broad focus on financial sector development as a whole, highlighting major areas such as the money market, payment system, and the capital market, as well as issues such as regulatory strategy, capacity building of financial firms and service providers, and financial inclusion. Many of the African countries are struggling with decision-­ making related to foreign exchange market policies, for reasons including the importance, for their economic development, of the strength and convertibility of their currencies and the soundness of their approach to capital mobility. Most of the countries also prefer stability of their exchange rates. This book argues that African countries should aim for social efficiency of their foreign exchange markets, which would include soundness of their foreign exchange systems, from an economic growth perspective, and fairness from an income distributional perspective. Finally, some of the African countries would like to have financial systems that are strong enough to be international centers of high-standing. The policy implications of that ambition are also discussed in this book. A policy strategy for developing such a financial center will include conceptualizing a financial center as a cluster; finding a niche for entry at the international level, in terms of clientele, products, and appropriate service provisions; enhancing competitiveness by building capacity, structuring incentives, and ­improving

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the quality of the national governance environment; and having in place high quality financial services supervision and regulation. Keywords  Governance structures • Systemic fundamentals • Selective intervention • Supervision • Regulation • Financial inclusion • Capital market • Foreign exchange market • Financial center • Value chains African countries have always realized that the financial sector is important for their economic development, mainly via its effect on saving, investment, and efficiency in resource allocation and product distribution. Hence, the countries are very interested in the growth and efficiency of their financial sectors as a whole and realize that they must devise sound rules, processes, and organizations within which those sectors must operate to achieve desired national objectives. This book is about the nature of the policymaking that will enable the countries to meet the challenges and attain the status of having sound, up-to-date and even world-class financial sectors. This book does not include a detailed structural survey of the state of development of different elements or characteristics of financial sectors, in various African countries, compared with more developed financial systems. It is simply about policymaking to continuously improve the state of development of the financial systems in the individual African countries. This chapter is an introductory survey of the contents of the chapters to follow. As would be expected, most African countries do indeed face major challenges as they seek to reform and develop their financial systems. Such challenges are reflected in diverse forms, of which a few well-known examples can be stated. First, poor systemic rules (institutions) and organizations are reflected in bank failures as well as in low bank profitability. The factors responsible can include loan and credit defaults, bad asset management, and risky foreign currency exposure. Second, as regards the foreign exchange area, many countries suffer from unstable currencies and deteriorating balance of payments, some of which may be due to poor domestic financial sector policies. Also, there is often societywide skepticism toward free and open foreign exchange markets and free-floating exchange rates, both of which lead to major and continuous official interventions in a country’s foreign exchange market. Third, due to poor investment environment and/or poor policymaking environment as a whole, the financial system often suffers from large and

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unpredictable variations in net capital inflows with adverse effects on foreign direct investment and exchange rate variations. Fourth, there is, too often, poor access to credit, by a very high fraction of the population, from regular formal financial organizations. In general, the main underlying challenge of financial inclusion is a big one in the African continent; luckily the countries are increasingly determined to make progress in that area. Fifth, there are serious weaknesses of national governing bodies in financial intelligence capacity to address money laundering, illegal financial transactions, and financing of terrorism. The main underlying factor is corruption, in diverse forms and locations, in the communities. This corruption is sometimes hard to control, because powerful individuals, business firms, and organizations benefit from it. Addressing, resolutely, the above-mentioned three problem areas is important. Sixth, a major challenge, for some countries, is developing methods to overcome technical difficulties in addressing risks and servicing costs, when authorities are pushing hard for ‘financial inclusion’. At the same time, some potential clients complain of high interest rates and fees charged by dominant banks because of servicing and other costs unrelated to risk; the dilemma for the authorities is that many believe that such behavior of banks appears as a deliberate attempt to keep small borrowers at length. Seventh, promoting saving behavior and increasing classes of assets that can legally serve as collateral for borrowing are challenges for some country authorities trying to increase access to financial institutions of some small businesses and low-income individuals. Eighth, some African countries have some distance to go before they truly will have the capacity to ensure sound supervision of banks and other financial firms (via normal prudential regulations, stress testing, and other forms of oversight). But covering that distance does not need to take a long time, with organization, technical competence, and analytic coherence in policymaking as well as determined policy implementation. In this book, we focus on the core policymaking elements that need to be designed and implemented to develop the financial system in ways that would ensure its optimal contribution to economic development and growth in any African country. The focus is on having a country achieve, as rapidly as possible, three coherent objectives, namely, greatly enhanced financial sector development, socially efficient foreign exchange market, and significant progress toward international financial center status. The hope is that, at least for the first two objectives, within a relatively short period

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of time, African countries that focus resolutely on developing and modernizing their financial sectors would be not too far behind the leading countries in the world. Chapter 2 is on getting the basics right on financial sector development policymaking. This chapter underscores the importance of a coherent policymaking environment that promotes sound governance structures (processes, rules, and organizational arrangements) for the financial system as a whole, systemic fundamentals (innovation system, human capital, and infrastructure) that will facilitate appropriate capacity building of the financial firms and organizations in the system, and appropriate selective intervention of official agencies (over and above regular supervision) to ensure, in particular, systemic stability, efficiency, fairness, and inclusiveness of the financial firms and organizations in the system. The intermediate objectives of such comprehensive policymaking, for the economy as a whole, could include boosting national investment, marginal efficiency of investment, and technological change and innovation. The ultimate objectives are economic growth and income distribution. Policymaking for financial sector development faces overarching challenges in a number of the countries in the continent. Lurking in the background of many of these countries are certain systemic issues and constraints, including low efficiency of many banks due to low skills and limited experience of their staffs; tendency of many banks to focus their lending on a few sectors in the economy; and tensions between the national official policymakers and some financial organizations (especially big banks) over particular issues, like financial inclusion policies and some elements of banking supervision guidelines. Nevertheless, the African countries realize the economic importance of making serious efforts to enhance national cooperation among the financial sector operators and between the operators and the national authorities, guided by international standards such as the Basel III, advice from international organizations like the International Monetary Fund (IMF) and the World Bank, as well by pressures from wanting to be a significant part of the global private financial system. Chapter 2 gives an overview of the analytic framework that African countries could take into account in designing and implementing a comprehensive financial sector development policy. The overriding goal is to ensure that the national economic policy framework for financial sector development takes clearly into account the general belief that financial sector development is good for economic growth and development. This

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means, inter alia, that the policymakers must find ways to know about current and latent (potential) effective demand for various types of financial services in order to help inform potential suppliers of financial services; in addition, the policymakers should strive, constantly, to create an environment with appropriate incentives for financial service suppliers to operate in socially efficient ways. In that context, financial sector development policymaking must focus on getting certain fundamentals right, in particular via capacity building (innovation system, human capital, and financial capability of the populace), microeconomic incentives to enterprises (openness, taxation, administrative barriers, and legal environment), and sound general governance (macroeconomic policies, socio-political governance, and compliance with appropriate international standards and codes). This chapter then turns to aspects of regulatory strategy, highlighting issues of financial risks and their management; the challenge of balancing the market and official regulation both of which can be quite strict and with very high standards; the nature and role of fiduciary duties in the context of corporate governance; ensuring that the compensation systems do not create incentives for risk-taking within financial firms; the nature of early warning signals, to ensure that they can be trusted to recognize, and comprehend promptly, appropriate signals of crises; and some perspectives on organizational structures of regulatory systems, which following tradition are expected to have clear objectives, autonomy, and expertise to do their job(s). Chapter 2 also focuses on the major policy areas in the financial system development process as well as on financial inclusion. The policy areas are money market development, payment system development, and capital market development. An active money market benefits the central bank in its monetary policy decisions and operations, the government in its budget finance operations, as well as portfolio managers, banks, and securities markets. Hence, serious attention needs to be paid to its evolution. As regards the payment system, this chapter includes, among other things, the argument that it is desirable for efficient and well-functioning financial markets to have at least one large value payment system that satisfies the ten core principles for systemically important payment systems suggested by the Committee on Payment and Settlement Systems of the Bank of International Settlements (BIS) in 2001. As regards capital market development, this chapter points out that empirical evidence clearly shows that stock markets have positive effects on economic growth, worldwide including African countries. Thus, for African countries, introducing, expand-

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ing, or ‘modernizing’ stock market(s) would be an important element in any strategy designed to facilitate economic diversification and growth. Financial inclusion has become a worldwide challenge of great interest. Financial inclusion is about available means of access to financial services, at affordable cost, by various income groups engaged in diverse production, consumption, saving and investment activities. The evidence is that financial inclusion matters for economic growth, reduction in poverty, and in dampening income and wealth inequality, as well as in enhancing macroeconomic policy effectiveness. Chapter 2 elaborates on the issues which are being widely discussed in the relevant literature. Policymaking on foreign exchange market issues remains a socio-­ political-­ economic complexity for the bulk of African countries. This reflects the fact that foreign exchange is extremely important for the countries, not only because exports and imports are important for them but even more so because hardly any of their own currencies is really significant as a medium of exchange in international trade and payments. Hence, they need to earn or borrow foreign exchange to import. This means that the determination of their exchange rates is a truly important issue. The effects on the welfare of their citizens are also enormous. The focus of Chap. 3 is policymaking to achieve socially efficient foreign exchange markets in these countries. The underlying premise is that if there is social efficiency, not only will the foreign exchange market be efficient in a technical sense, but also the individuals and firms that operate in the market will consider its operations sound and fair whether from an economic growth or a distributional perspective. This chapter elaborates on the concept of social efficiency of the foreign exchange system and discusses the governance issues, including oversight and selective intervention, as well as exchange rate regime objectives. This chapter also briefly addresses forex market development policies, the nature of systemic fundamentals of the country that would help facilitate national social welfare optimization, and the nature of selective intervention in the forex market—notably by the central bank—that would be relevant in this context, while helping to allay the fear of floating exchange rate by the population at large. Attaining international financial center status, of any degree, will remain a dream for most African countries, for some time. Chapter 4 addresses this issue. Mauritius and South Africa are already far along the way, and at least three to four other African countries can attain that status and be inside the top 100 countries within a couple of decades if they are determined to take the necessary policymaking steps. In this chapter, we argue

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that the geographical area in which an international financial center is located must be attractive as a place where people want to live, work, and visit. We outline a strategy for developing such a financial center, which includes the following: (1) conceptualizing a financial center as a cluster; (2) finding a niche for entry at the international level; (3) enhancing competitiveness by building capacity, structuring incentives, and improving the quality of the national governance environment; (4) putting in place high quality financial services supervision and regulation; and (5) promoting the center by assisting it to access global value chains, implementing other appropriate and beneficial selective intervention policies, and granting it some enclave privileges.

CHAPTER 2

Getting the Basics Right

Abstract  Financial sector development can occur in the context of spontaneous order. The premise of this chapter is that coherent policymaking and implementation can speed up that process, applying directly knowledge gained from relevant theory and analytical framework, historical experience, and other empirical evidence. In this light, the chapter discusses coherent financial sector development policymaking and implementation by country authorities. Important aspects of the process would be getting the fundamentals right; designing sound governance structures, including appropriate regulatory and supervisory systems and standards; and focusing directly on major areas such as money market development, payment system development, capital market development, financial inclusion, and insurance. Keywords  Spontaneous order • Regulators • Supervisors • Stock market • Money market • Capital market • Payment system • Credit rating • Insurance • Systemic fundamentals • Selective intervention • International standards and codes • Transaction costs • Capital buffers • Microeconomic incentives • Early warning signals • Tiered regulation • Market discipline • Discount window policy • Reserve requirement policy • Investment banking • Digital banking • Financial capability • Financial inclusion

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Financial sector development, even in the context of spontaneous order, has made significant contributions to economic growth and per capita real income. Still, financial sector development benefits from appropriate public sector policymaking and implementation. Indeed, public sector policymaking can help ensure that financial sector structures and operations are socially optimal, thereby helping to maximize the financial sector’s contributions to national economic welfare. Public policy objectives, among other things, typically include helping to create incentives to ensure that the financial system optimally mobilizes savings and other fungible ‘funds’ from various sources and efficiently allocates the associated funds among investors and other users, while applying up-to-date techniques of risk management to prevent credit and loan defaults. The performance of the financial system greatly depends on key ‘players’—sometimes classified as savers, investors, borrowers, lenders, liquidity providers, and regulators (see, e.g., Chami et  al. 2010)—who directly or indirectly help design the processes, rules, and organizational arrangements (the governance framework) of the system. In such a context, whether via spontaneous order and/or via the country authorities’ actions and directions, financial sector reforms and development will be continuous activities. Financial systems perform five basic functions that have been highlighted in the finance and growth literature (see, e.g., Levine 1997). Namely, they (1) facilitate the trading, hedging, diversifying, and pooling of risk; (2) allocate financial resources among competing users; (3) monitor managers and exert corporate control; (4) mobilize savings in all the geographical areas they serve; and (5) facilitate the exchange of goods and services. The performance of these functions then affects economic growth, inter alia, by increasing the incentives for capital accumulation and technological innovation. In their day-to-day activities, the firms and individuals in financial systems can be observed advising clients, structuring and arranging deals, providing finance to borrowers and equity issuers, and managing funds and investments of individuals and so-called institutional clients. Indeed, the importance of the financial system for the economy is highlighted, especially during periods of major financial crises when the financial sector seriously malfunctions or indeed becomes seriously unable to perform most of its functions as smoothly as it normally does.1 Available evidence indicates that, other things being equal, countries with larger banks and more active (liquid) stock markets with substantial value trading grow (and develop) faster than other countries. In general,

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banks and stock markets facilitate increased amounts and efficiency in investment of physical and human capital (given the state of technology) as well as technological change and innovation. Hence, industries and firms that rely heavily on external financing grow disproportionately faster in countries with well-developed banks and securities markets than in countries with poorly developed financial systems (see, e.g., Levine 1997; Levine and Zervos 1998; Demirgüç-Kunt and Levine 2008). There is some element of reverse causation as well. In other words, economic activity and technological innovation affect the structure and quality of financial systems. As an element of that process, financial system development is being affected by innovations in telecommunications, digital communication, and information and computing technology, as well as by legal, political, and economic institutions and organizations of countries (see, e.g., Levine 1997; Demirgüç-Kunt and Levine 2008; Nso 2018; Shin 2018). Indeed, of particular importance has been the objective of countries to accelerate access to the internet (at affordable cost) of the whole population. The challenge, of course, includes being able to manage the risks involved. The most developed financial systems are international in their scope and daily general operations (and hence often called international financial centers). At its most dense, such a center will actually be a form of cluster containing a substantial number of fair-sized financial services firms, major international accounting firms, as well as legal services and telecommunications and computer engineering firms (including consultancies). The financial services firms in such a center will be highly diversified with some of them engaged in activities covering the whole spectrum in major areas like banking, securities, foreign exchange trading, insurance, derivatives, fund management, and various specialized professional financial services. African countries differ widely in the state of development of their financial systems. In this chapter, we focus on several issues being addressed or that need to be addressed by African countries, in general, as they design and implement strategies to ensure satisfactory financial sector development in light of the potential contribution to economic growth of the countries and to welfare of their citizens. The analysis builds on the rich stock of international knowledge and experience in these areas. We focus especially on policymaking that seeks to get the systemic fundamentals ‘right’ and thus fosters economic growth and development, financial

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system safety and stability, and fair access to all potential users of the system (households, firms, and the public sector).2

Toward Coherence in Policymaking There is a substantial literature indicating the benefits of financial sector development from which policymakers in African countries by now should know the importance of implementing sound policies that would advance financial sector development in their countries.3 Much of this literature is, naturally, based on evidence that financial sector development is good for economic growth and development. But the interaction between financial sector development and economic growth is not simply one in which the financial sector gets developed and the positive effect on growth follows. In fact, financial growth could be motivated by economic growth potential of the country, complicating the line of causation between economic growth and financial growth. In such a context, the African countries need to appreciate the complexity of the appropriate policymaking and implementation requirements. In that regard, policymaking to boost financial development must reflect on a few questions. First, is there clear evidence of a latent effective demand for financial sector services that are not ‘adequately’ being provided? Second, if there is latent unsatisfied effective demand, do financial services suppliers know about this demand? Third, if financial services suppliers know about this effective demand, then why are they not supplying the services to the extent that policymakers would like to see? Is it because of financial services supply cost, or because of the national policy environment or the general business environment of the country? Fourth, if suppliers are in fact providing the services, at costs the demanders can afford, then why is effective demand not as strong as policymakers would like, from an economic development perspective? Is it because of the macroeconomic policy environment due mainly to public sector policymaking and implementation, or is it because of disinterest (due perhaps to low private profitability relative to social profitability) of the suppliers of goods and services in the financial sector? Whatever is the case, it would seem that the strategy of policymakers should include the following: • Continuous research on effective demand for various types of financial services (see, e.g., World Bank 2018)

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• Identify potential suppliers of various types of financial services, based, inter alia, on information got from the work of supervisors and regulators as well as from the government and the central bank in their interactions with, and research on, banks and other financial services providers • Provide information, freely or at very low cost, to potential suppliers of the financial services, on the extent of potential demand for particular services • Help create an environment (especially in the context of supervision, regulation, and taxation) with incentives for financial services suppliers to supply their socially valuable services at ‘reasonable cost’ to the potential demanders of the services • Design and implement a national economic policy framework (micro and macro) to ensure that the equilibrium distribution of financial services, across the population and the economy, is optimal from the perspective of economic growth of the country as a whole. Ongoing research on the ground, in the African countries, shows clearly that financial firms respond to significant opportunities for profit and that such response facilitates economic development when the enabling policy environment of the country is appropriate, from the perspective of the service providers (see, e.g., Chirunga et al. 2018; European Investment Bank 2016). Indeed, one sees the same incentive for profit in the development of diverse types of financial sector services, one of the most interesting and notable being mobile money (see, e.g., Suri 2017). As regards coherence in policymaking, African countries need to be careful, in their focus, not to ignore some major areas in financial sector development that are clearly underdeveloped and need comprehensive development work. In particular, many of these countries need to pay increased attention to areas such as the payment system, the stock market, and credit bureaus.

Sound Environment for Financial System Policymaking Financial system development and stability benefit from a coherent and sound policymaking environment that ensures (1) governance structures (rules and regulations) that promote dominance of sound financial firms

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and organizations; (2) systemic fundamentals—macroeconomic environment and payment systems, in particular, but also the national innovation system, human capital, and infrastructure that improve the productive capacity of the economy as a whole4—facilitating capacity building of financial firms and organizations, and, enhancing the profits and ensuring the survival of those that are most socially productive; and (3) selective intervention policies, of official (public sector) agencies, to promote (in socially optimal ways) stability, efficiency, fairness, and inclusiveness of financial firms and organizations in their operations. The intermediate objectives of this coherent and sound policymaking environment are to boost national investment, the marginal efficiency of investment, and technological change and innovation. The ultimate objectives of the policymaking environment are economic growth and income distribution. All the elements of the policymaking environment can therefore be construed as instruments that help trigger the development of the financial system. From a governance perspective, the elements of the financial system to which special attention needs to be paid are the money market, the payment system, and the capital markets. Also important are coherent policies that address certain access to finance questions, particularly finance for small and medium enterprises (SMEs), saving facilities for the lowest income individuals and groups, and insurance (particularly micro-­ insurance and crop insurance, and in many countries, also, health and life insurance). The financial sector regulatory framework is very important in this context. There are, at least, three major consequences of a high-quality regulatory environment for financial sector development. First, a high-quality regulatory environment will have a positive effect on cooperation among the firms in the financial sector, since all the firms will trust each other more than if the regulatory standards were suspect. Second, financial firms outside the country will look favorably on building relationships with the financial firms and markets in the country. Third, authorities in other countries will be less prone to imposing tight regulatory standards on dealings of their local financial firms and markets with financial firms and markets in the developing (African) country concerned. From the perspective of growth and financial sector stability, the regulatory strategy in a high-quality regulatory environment must achieve two overriding objectives. First, it must ensure clear understanding by regulators and financial firms of risks faced by the financial firms and how those risks could be managed. Second, the regulatory strategy must be clear

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about the role of regulation versus the market in ensuring that the financial risks are efficiently managed and controlled. The regulatory agency or agencies of the country must ensure that the human and nonhuman capacities are there—within the regulatory community and the financial firms—to understand and manage the financial risks faced by the financial firms of the country. The regulatory agencies must set standards and must also oversee internal processes of firms to ensure that they are appropriate and sound. Still, financial firms should take primary responsibility for their risk management. An optimal regulatory regime and strategy, among other things, will balance regulatory rules, supervisory review, and market discipline (see, e.g., Llewellyn 2002). In practice, there is always a need to balance regulation, on the one hand, with market discipline, on the other. In the end, the relative weights will vary from one country to another and perhaps among types and sizes of financial firms as well, depending on the particular circumstances. Some of the determining factors, for a country, would be the available expertise within financial firms and within regulatory agencies, the nature of the risks faced by the financial firms, and the relative sophistication and efficiency of the pool of others who could monitor the management of the financial firms. As regards systemic fundamentals, also important are the technological environment and costs of available facilities—electronic and telephone banking facilities, computer availability and cost, internet and e-banking facilities (hence mobile money); aspects of the macroeconomic environment that affect the financial system and to which the financial system can only consider as a constraint on their activity in the sense that they have to adapt to it more than they can control or constrain it; and the quality and the socio-political constraints of the national policy approach to financial market development. The governance and systemic fundamentals indeed affect selective intervention policymaking. Hence, the official supervisory agencies, the central bank, and the government policymakers need to continuously review the ‘why’, ‘where’, ‘when’, and ‘how’ official intervention(s) in financial market operations (in particular the money and foreign exchange markets) is/are ‘socially’ optimal. For instance, important and ideal would be a clear understanding and agreed social contract as regards the role of the private sector and of the state in financial market development, standards-­ setting, and in oversight of financial market operations. No

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doubt, peer pressure, especially via international standards and codes, would help guide such debates in the typical African country.

Governance The elements of the governance environment are processes, rules (sometimes otherwise termed ‘institutions’), and organizational arrangements. Hence, for example, the regulations and incentives that are intended to motivate the firms and organizations in the financial sector, to help achieve the goals desired by the national authorities, could be categorized under these three elements. Whatever are the detailed elements of the governance environment, they work via incentivizing, enabling, and/or constraining crucial actions that need to be taken or avoided, as required, to ensure success of the financial sector development program. Designing and Implementing a Financial Sector Development Program In designing a financial sector development program, it makes sense to pay special attention to the major elements of the incentive structure governing behavior.5 For instance, the institutional structure will include the conventions and codes of conduct, the freedom to contract, and the property rights structure (e.g., ownership rights, rights of transfer, appropriability of earnings from one’s assets, and the internalization of costs and benefits from one’s activities). This is one reason why coherent and reasonably comprehensive legal and regulatory frameworks are extremely important. So, also, are rules and regulations governing clubs and associations (e.g., forex clubs, bankers’ associations, accounting associations). Still, by law, by negotiated agreement, or by ‘tradition’, institutional arrangements can be allowed to evolve in their design to continuously enhance the efficiency of the financial system. The ‘institutional arrangements’ of concern, will specify, for example, (i) rules, codes of conduct including fiduciary obligations, and procedures in interactions; (ii) uniform guidelines in formulating different types of contracts; (iii) uniform standards and measurements for commodities and services; (iv) assessment and evaluation standards (credit ratings, etc.); (v) common technical language for communications, (vi) common value dates for money, exchange, and securities’ transactions, (vii) uniform computer codes and languages for financial transactions; and (viii) standard chart of accounts for use by banks. These elements, in turn,

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help promote well-functioning and orderly competition, exchange, intermediation, and arbitrage. It is therefore important that core rules are transparent, widely dispersed, well-understood, and strictly enforced. Social Efficiency of Financial Markets Matter The social efficiency of financial markets will tend to be enhanced: (i) the more competitive are markets; (ii) the higher the level of expertise of market participants; (iii) the more internalized are the costs and benefits of actions of the market participants; and (iv) the more quickly market participants respond to price signals using efficiently all the information at their disposal. Social efficiency of the financial markets will influence social efficiency of the financial system. To investigate social efficiency of the financial markets, one would tend to look at a number of indicators. These would include (i) barriers to entry (hence degree of openness of a market); (ii) the degree of segmentation of the market for a particular asset (e.g., government securities, foreign exchange) across regions or across groups of firms of the same country; (iii) the number of firms in a particular market; (iv) the variety of financial instruments in the market; and (v) the diversity of participants (brokers, dealers, market makers) and the degree of specialization by functions and by assets. Transaction and Operating Costs Transaction and operating costs in financial markets show up as buying and selling spreads, commissions and brokerage fees, various kinds of dedicated service fees and charges, insurance costs, costs of dealing with cybercrimes, and risk premiums. These costs, in turn, include the costs of making computations and of record-keeping (e.g., labor time used in paperwork and accounting), acquiring and processing information, buying and using appropriate equipment and well-trained operators and service personnel, assessing risks (including the credit standing of counterparties in transactions), measures taken to deal with residual risks (including insurance), enforcing contracts and agreements, marketing, and policing property rights in general. Transaction costs reflect genuine opportunity costs of resources used in transacting, managing, and policing; such costs can often be reduced by institutional reforms or modifications of market structure. In other words,

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the level of transaction costs in relation to the total value of the commodity being transacted partly reflects the state of development of financial markets and of the supporting infrastructure in the economy at large (communications facilities, computer facilities, adequately trained personnel, etc.).

Major Policy Concerns and Overarching Challenges in Most African Countries As regards the basics, there are three very important sets of financial sector policy concerns in African countries, with varying degrees of importance in different countries. These concerns are (1) financial sector development in general; (2) prudential regulations and supervision adequate enough to ensure safety and soundness of financial firms as well as stability of the financial system as a whole; and (3) financial inclusion—that is, market conduct that promotes fair treatment of all actual and potential customers (especially with respect to access to financial products and services), sound consumer protection, and financial education adequate enough to ensure high level of financial literacy and capability.6 The state of financial sector development in African countries covers a wide spectrum. Still, the overwhelming majority of them can benefit from major systemic development while the few that have fairly diverse and developed structural systems can still benefit from further institutional, organizational, and regulatory reforms. African countries have fairly liberalized financial systems. Interest rates and exchange rates are also normally market-determined; currently, there are really no formal effective selective credit controls under normal conditions; and even where state-owned commercial banks exist, the banking system is not government-dominated in its activities. Still, cash and liquidity requirements, which banks have to follow, can sometimes constrain the structure of banks’ asset portfolios in ways the banks find unprofitable. So do certain exchange rate and foreign exchange market controls in a number of macroeconomic situations of particular countries. Addressing the policy concerns are made even more difficult by some overarching challenges, some of which can be highlighted. In general, a high fraction of banks in many African countries are small (assets averaging about $45 million); efficiency is low (noninterest expense averaging just more than 10 percent of total assets, and interest rate spreads some 10.8

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percentage points); there is high concentration in the banking sector, despite recent improvements (in many countries three to four of the largest banks hold more than 50 percent of total assets); and the skill and experience level of bankers, in many of the countries, are deemed ‘low’ on average. Lending activities of banks also tend to focus on a few sectors, namely, trade, construction, manufacturing, and real estate. The funding conditions of banks tend to be tight on the whole in most countries, aggravated by the fact that borrowers often want to borrow in foreign currencies.7 Added to this is the fact that many of the participants in the financial sectors, especially the big banks, feel a pressure to assist in the attempt of policymakers to widen the circle of ‘financial inclusion’ because of the benefits to economic development of the countries. Hence, inter alia, banks are finding ways to widen their lending markets, especially to small and medium enterprises (SMEs); increase their deposit funding circle; and at the same time raise their operational efficiency. In the context in which they operate, the private financial institutions may need to participate in financial education of the population, in addition to finding ways, where possible, to continue simplification of financial procedures for depositing, saving, and obtaining credit in their organizations. On the whole, African Stock Exchanges (see Table  2.1) are small, in terms of gross listings, apart from the Johannesburg Stock Exchange. Still, apart from South Africa, the world ranking in stock market capitalization (i.e., percent of gross domestic product [GDP]) is fairly high also for Mauritius and Morocco.8 Not surprisingly, the soundness of the financial system varies widely across the countries in the continent. Still, the overwhelming majority are not in any danger of crises. Some countries still find it a challenge to decide on basic issues, like the assessment of asset quality, the optimal level of capital-­ asset ratios and liquidity ratios for various sizes and types of financial institutions, or how to contain nonperforming loans from being a recurring problem (say, e.g., because of slumping commodity prices or currency depreciation). Luckily, the African countries are addressing these issues and developing analytical approaches, based on their increasing experiences as well as guidance from international organizations and lessons from the varied experiences of countries around the world. On the whole, the state of banking supervision still needs a lot of work in many of the African countries as the challenges faced by such supervision are increasing due especially to domestic economic development pressures. The African countries are all aware of their shortcomings and it

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Table 2.1  Table of African stock exchanges Algeria Angola Botswana Cameroon Cape Verde Egypt Ghana Kenya Lesotho Libya Malawi Mauritius Morocco Mozambique Namibia Nigeria Rwanda Seychelles Sierra Leone Somalia South Africa Sudan Swaziland Tanzania Tunisia Uganda West Africa (French) Zambia Zimbabwe

Algerian Stock Exchange (SGBV) Angolan Debt and Stock Exchange (Bodiva) Botswana Stock Exchange (BSE) Douala Stock Exchange (DSX) Cape Verde Stock Exchange (BVC) Egyptian Exchange (EGX) Ghana Stock Exchange (GSE) Nairobi Stock Exchange (NSE) Maseru Securities Exchange (MSM) Libyan Stock Exchange (LSM) Malawi Stock Exchange (MSE) Stock Exchange of Mauritius (SEM) Casablanca Stock Exchange (CSE) Mozambique Stock Exchange (BVM) Namibian Stock Exchange (NSX) Nigerian Stock Exchange (NSE) Rwanda Stock Exchange (RSE) Seychelles Stock Exchange Sierra Leone Stock Exchange Somali Stock Exchange (SSE) Johannesburg Stock Exchange (JSE) Khartoum Stock Exchange (KSE) Swaziland Stock Exchange (SSX) Dar-Es-Salaam Stock Exchange (DSE) Bourse de Tunis (BVMT) Uganda Securities Exchange (USE) Bourse Regionale des Valeurs Mobilière (BRVM)9 Lusaka Stock Exchange (LuSE) Zimbabwe Stock Exchange (ZSE)

Sources include, especially, http://african-exchanges.org/en

is fair to say that they are all working toward full implementation of the Basel III recommendations, internationally formulated under the auspices of the Bank for International Settlements (BIS) in 2010 and revised in 2011 (see Basel Committee on Banking Supervision 2011). These efforts are especially visible in the areas of enforcing strong capital requirements including sound capital buffers,10 to protect banks from unexpected serious losses due especially to adverse systemic shocks; preventing ‘excessive’ interconnectedness among systemically important banks that can transmit shocks across the financial system; and, for all financial institutions, ­ensuring strong liquidity base and sound principles of liquidity management, inter alia, to ensure smooth functioning of money markets.

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In most of the countries, the African financial institutions (mainly banks), motivated by supervisory requirements, are making efforts to raise the level of risk management expertise in their staffs. Still, on the whole, a significant fraction is struggling to manage satisfactorily the classical risks faced by such organizations, namely liquidity, credit, interest rate, market, foreign exchange, operational, sovereign, legal, and fraud risks. In sum, many of the countries’ regulatory organizations, including central banks, face serious challenges in trying to ensure safe and sound financial systems that should also be growing and developing in ways that enable them to contribute as significantly as possible to the growth and development of the countries’ economies. The payment system in a significant number of the countries is still rudimentary, with no interoperable ATM (automated teller machine) system, little or lack of widespread credit card use in domestic payment transactions, very moderate use of checks or internet banking, and no electronic large value payment system. There is also no country-wide local credit rating agency in the bulk of the countries. Such agencies help improve the functioning and efficiency of credit markets, basically by reducing the cost to the lender of determining the borrower’s true creditworthiness11; both the lender and the borrower gain. Although there is no sound available empirical evidence on the matter, casual observation also leaves one with the impression that many of the commercial banks in the continent do not have the data and/or developed internal processes that go beyond so-called traditional approaches in credit risk management; in that context, most of the lending would depend on so-called expert systems among these traditional approaches.12 Indeed, in many (perhaps the majority) of the countries, the normal financial markets (such as short-term credit, medium- and long-term credit, and foreign exchange) are rather rudimentary and not really well-functioning (open, competitive, and maintaining international market standards in their daily operations). In sum, many elements of a first-class financial system, including high-percentage financial inclusion rates (see below), remain to be achieved by the bulk of these countries. To begin to address, coherently, the financial sector development challenges, most of the African countries need to work on what we can call the systemic fundamentals for productive capacity building in the economy as a whole; a low level of development in such fundamentals is bound to affect, adversely, development of the financial sector. We mean here, in particular, a country’s innovation system, human capital, and infrastructure (see

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Johnson 2016, pp.  18–20). Without substantial stock of high-quality assets and systems in these areas, the financial sector development process is bound to be very slow.

Financial Sector Development Plans across the Continent The financial sector development and modernization plans in many African countries emphasize eight major interrelated areas for attention: (i) building commercial banking sector capacity to perform their functions in modern domestic and global financial systems; (ii) increasing access to finance (‘financial inclusion’) of all capable economic agents in the country, and transparency of financial products and services to all, including low-income households and small and medium enterprises (SMEs); (iii) strengthening short-term financial markets; (iv) modernizing the domestic payment system; (v) improving the financial system’s capacity to mobilize and invest medium- and long-term funds; (vi) strengthening financial sector supervision and regulation, including the financial intelligence system addressing money laundering, financing of terrorism, and various other illegal activities13; (vii) strengthening central bank capacity to play a leading role in the analytic, design, and certain monitoring and regulatory work in the financial sector plans; and (viii) improving macroeconomic policymaking and implementation of the government, inter alia, to bolster the capability of both the government and the central bank, supported by well-functioning financial markets, to ensure financial system stability and ability to cope with real shocks emanating from both domestic and international markets. We turn now to suggest a coherent analytical approach to policymaking, for the development of the financial sectors, which we believe would be useful in the bulk of the African countries. Of course, some elements of this approach are already being implemented in many of the countries.

Getting the Fundamentals Right: Capacity Building As in so many other activities, reputation is important in the financial services business. Credibility of promises and a belief that the authorities are serious and committed to building a world-class financial sector will flow from good reputation. Capacity to do the job well, as revealed by

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competence and integrity of the firms and service providers that operate in the financial sector, enhances reputation. As is recognized, in varying degrees of the typical Financial Sector Development Plan (FSDP) of many of the countries,14 a strategy must therefore be put in place to build capacity of the people and organizations in the financial system to perform their tasks well. We would argue that the relevant capacity building will be facilitated by the quality of the national innovation system, human capital, and financial capability of the populace of the country as a whole. Innovation System Innovation is, obviously, important in the financial services industry and it is a continuous process, which of course poses great challenges for regulators. The concept of a national innovation system is useful in ordering one’s thinking in this regard.15 A national innovation system is the set of institutions, organizations, and mechanisms supporting technical innovation in a country. In the current context, one would, for example, be interested in the processes by which firms in the financial system master, use, and supply products and procedures that are new to them. Innovation for any particular firm or organization will include copying and catching up with products and practices of others; appropriate adaptation of existing products to the specific clients and/or environment of its own sub-system; investment in new equipment; organizational reforms; learning new skills, including technical and analytical knowledge (mathematics and statistics, finance, economics, etc.); and adopting new approaches in marketing and cooperation with financial centers around the world. An objective of policymaking in the context of the national innovation system is, in short, to enable domestic firms to develop sufficient technological, organizational, and scientific sophistication and adaptability to function effectively when compared with some other financial systems in the global environment. Strengthening the national innovation system as a whole and making it supportive of the financial services sector would involve looking at the quality of secondary schools; programs at universities, research centers, and institutes; technical and vocational training in the country; and training and research programs within firms in the financial sector. Apart from training and research facilities, there are other important factors that will bolster the innovation system and that the authorities must influence. Among these, habits and practices of major actors in the financial system are

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important. Firms must be motivated to inculcate habits and practices that encourage innovation. In that regard, the incentive structures within the financial firms matter. The competitive environment is also important. National policy fostering open markets and safeguarding their integrity will be good for innovation. Appropriate incentives will also encourage innovation and survival of only strong firms that tend to be more innovative. Labor management relations matter, inter alia, because they can influence employees’ attitudes and commitments toward technical change and innovation. Moreover, availability of finance to support innovation (especially acquisition of equipment and training) is extremely important. Government policies can influence all of these elements that affect innovation, as can cooperation among firms and organizations in the system. Human Capital The quality of the human capital in the financial system is crucial to financial development. The technical capability, innovative ability and integrity of the human beings operating in the system, and overseeing its markets and organizations are important dimensions of this quality. The indispensability of high-quality people to achieving a high degree of competitiveness has forced all financial centers seeking to compete at the international stage to be open in their recruitment policies, acquiring the appropriate people from wherever they can be found. African countries can, no doubt, benefit from adopting such an attitude. Given the benefits of rapid financial development, African countries should continue the process of opening up to relevant and reputable international firms—especially banks, insurance companies, rating organizations, and accounting firms—from all over the world. The authorities in African countries should not only welcome such international firms to their countries but also refrain from restricting their flexibility in personnel management. Similarly, fund managers, advisors, and consultants of ­foreign origin should be encouraged to open offices in an African country if they so wish. High-quality labor pools would enrich the countries. Two areas with thorny issues, which all financial sectors around the world have had to address, are labor policies and personal income taxation. In the case of labor policies, the main issue is the degree of freedom and flexibility that the top management will have with respect to hiring and firing, overtime pay, minimum wage, leave, treatment of unions, and

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hiring of foreigners at all levels of the firm. A cautious approach would be to take a survey of what countries with leading financial centers are doing at the moment and adopt a mix of policies that are sufficiently flexible and also would be fair to the workers in the African country concerned. The same can be said for personal income taxes. First and foremost, a country should negotiate double-taxation treaties with at least those countries where the risk of double-taxation exists. As to the level of taxation, when relevant, the advice again would be to do a survey of the leading financial centers and get a good idea of their personal taxation, both of nationals and of foreign nationals who are residents in the country. Then an attempt should be made to modify domestic taxation laws to become competitive. Financial Capability of the Populace Other things being equal, it seems reasonable to expect that persons with enormous financial capability, namely, ‘the knowledge, skills and motivation to manage their finances’ (HM Treasury 2007, p. 3), will tend to use financial systems more than persons with low capability. Indeed, those with high financial capability will have greater ability to reap returns from their savings and will be willing to explore alternative ways of investing their assets and managing financial risks. Having a large proportion of the population with a high level of financial capability should motivate more business for a national financial system than otherwise. The United Kingdom, several years ago, introduced a useful initiative, elements of which are worth copying by many of the African countries. The idea was to put together a coherent program to enhance the financial capability of the population. The overall strategy was to include supply-side policies to enhance general access to both financial services markets and to good but affordable financial advice. The expected outcome of the strategy was ‘better informed, educated and more confident citizens, able to take responsibility for their financial affairs and play a more active role in the market for financial services’ (HM Treasury 2007, p. 7). One obvious indication of the relevance of this approach for an African country is that when one looks at the typical African country, planning for retirement and old age has always been a challenge, abated only by the willingness and ability of the younger generation to voluntarily care for their old citizens. A few African countries have established something along the lines of what, for example, Sierra Leone calls the National Social

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Security and Insurance Trust (NASSIT), which is designed to go some way in remedying this problem. But, a NASSIT, by its nature, covers mostly the formal sector, which still remains smaller than the informal sector of probably the majority of African economies. Taking a cue from the British approach, key elements in an action plan for an African country would be: promoting appropriate education (mathematics, finance, etc.); improving avenues for information and advice; increasing availability of opportunities to practice and develop appropriate skills; and instituting outreach programs. The central bank of the country could lead the effort, in partnership with the government, the financial services industry, and civil society organizations of interest. Other countries have programs that achieve some of the same objectives as the UK one and apply some of the same tactics, most notably introduction to personal finance education in schools. Businesses and voluntary associations and organizations offer free programs to young people and economically disadvantaged persons in other countries as well. Moreover, it is possible to obtain much of the training and the advice in the open market. The idea would be to have a high degree of planning and overall coherence and to offer much of the program without significant monetary outlays from the beneficiaries. Indeed, in most African countries, formal finance education, advice, and outreach programs are not widely available in schools, charitable organizations, or the financial services industry. Hence, a publicly organized financial capability program would seem to be of much social value. As in other programs, with this sort of planning it is always useful to organize some sort of a survey so as to fully understand the nature and dimensions of the problem to be tackled and the seriousness of the different aspects of the problem. Hence, it would be useful for a country’s authorities if they want to mimic this effort to organize such a benchmark survey.

Getting the Fundamentals Right: Microeconomic Incentives to Enterprises The policy environment will affect the economic returns to the people and firms that operate in the financial sector. If these returns are low, people and firms that can earn higher returns elsewhere will leave, until an appropriate stock is left, such that the marginal returns to those who stay equals

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the returns they would earn elsewhere. To make matters worse, if the policy environment is unfavorable or unpleasant, even the highly productive human capital developed within the country could actually flow out of the country. In short, it is extremely important to have adequately competitive incentives in order to attract and retain high-quality people and firms to operate in the financial sector concerned. Some of the incentive issues have already been addressed. We can mention here that the quality of life also matters in attracting talent. Hence, making the country attractive to live in will be a positive incentive to enterprises. Later, we will briefly discuss governance issues, which also can affect the structure and hence the behavior of enterprises vis-à-vis the financial sector. We now briefly discuss issues of openness, taxation, administrative barriers, and the legal environment. Openness The financial sector will benefit from the presence of strong firms—by definition, firms that can survive in open competitive markets and can build the capability to export their services. In order to attract such firms and keep them, an overarching requirement is the maintenance of an economic environment (markets, institutions, immigration laws, information flows, ideology, and access to the authorities) that is open. An open environment will exhibit several characteristics. First, there will be fair and open access rights to all to locate in and/or do business with the country’s financial sector, irrespective of national ownership of a firm. Hence, firms with 100 percent foreign ownership will be welcomed. Especially in the early stages of financial development, such firms have the potential, when properly screened using objective standards, of bringing badly needed expertise and business connections to the local financial sector. Second, ‘firewalls’ limiting the types of business to be engaged in by the same firm/organization will not be too restrictive—that is, not out of line with the leading financial centers of the world. Third, innovation will be encouraged—that is, not facing regulatory and other obstacles that are more stringent than those found in the leading financial centers. Fourth, institutionalized procedures will exist through which policymakers and regulatory and supervisory authorities consult and elicit the opinions of financial services providers before implementing new or revised rules, taxes, and other costly obligations on the financial sector markets, firms, and people. The authorities must also demonstrate that they seriously

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consider the views and analyses of the financial sector organizations before finalizing their decisions. Fifth, there must be a high degree of freedom and flexibility allowed firms in their day-to-day operations, again taking due account of the capabilities of the financial firms. Hence, such firms must be allowed capital mobility,16 currency convertibility in an open foreign exchange market, and implementation of human resource management policies that enable them to accumulate the human capital they find optimal. Taxation The various kinds of taxation to be considered, in financial sector policymaking (reform and development issues, of course), would normally include corporate taxation; taxation of wages, salaries, interest, and dividends; taxation of capital gains; and taxation of specific transactions. In addition, there can be other kinds of taxes in the form of fees that are not labeled as ‘taxes’; rather, they may be called registration fees, stamp duties, and transfer fees. Governments in their tax policies, as a whole, are usually concerned with the size of government revenue, fairness across income groups, and systemic efficiency of the tax policies. In the context of a financial sector, it is useful for the country’s authorities also to see the problem as one in which they are trying to promote production (of financial services), enable the financial sector to attract and keep talent, and for the country to attract valuable foreign direct investment to the financial sector. In short, taxation directed at the financial services sector and subsectors must not do damage to the international competitiveness of the country’s financial sector. In many, perhaps most, of the African countries, it should be obvious that the bargaining power (i.e., the special nonpecuniary attractions and indirect pecuniary benefits) of operating in the countries’ financial sectors is not likely to be enormous for some decades to come. So, there will be no ‘rents’ to be captured. This means that the solution to the tax problem is straightforward. The taxes mentioned earlier cannot, in their total burden on the firms and the highly talented employees, be higher than competitor financial sectors of many other countries, particularly outside of the African continent. In fact, it would seem that the general burden of the different taxes should be at least as favorable as the most favorable of the top-50 financial centers in the world.

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Similarly, if special incentives are granted to investors of any kind, there is no reason why investors in financial services should not qualify for similar benefits, as appropriate.17 A general advice would be to look carefully at what others are doing and be as competitive as possible with respect to the types and levels of taxation. Double-taxation treaties, for instance, should be signed where useful. Many countries have also been directly addressing certain specific taxes that are relevant in this area. One could benefit from what those countries are doing and at worst match the most favorable ones, in order to be competitive. In its attempt to examine the tax code to remove elements that would be discouraging to the development of a sound financial sector, the African country concerned may use the opportunity to reform the whole tax system. A compelling reason may be that some taxes may not be easy to remove or to lower for the financial system without doing so for the whole economy. A way around this may be to make the financial sector an enclave that will allow it to enjoy special tax privileges not enjoyed by firms, organizations, and individuals outside the enclave. Such an approach is likely to be useful and possible for some countries but not all. Administrative Barriers On the face of it, the administrative barriers to doing business in many African countries are not as great for the financial sector as for many other sectors in those economies. Yet, it may still be possible to reduce whatever administrative barriers exist to smooth operations in the financial sector, especially for foreign firms and individuals. In brief, the barrage of licenses, approvals, permits, and other requirements should not unduly raise the costs of setting up and doing business in the financial sector. For example, any lingering recurring problems with utility companies, the tax and port authorities, and the immigration office could be greatly alleviated. Of course, improvements should benefit all the firms and organizations in the financial sector not only those with foreign ownership. Legal Environment The law, the courts, and the police, in some countries, all need to be reviewed in light of the requirements to make the financial sector grow and be efficient and competitive. It would be advisable to do a formal review of the legal system in light of the experience of the top international

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financial centers in the world to ensure that the legal framework is adequate. Even casual observation reveals that the regular courts in some countries, in their operations, are way below the normal level of efficiency required to support the financial system rather than to be an obstacle to the system’s development. The evidence on this score must be clear, since the courts have been handling cases in which the financial services sector has been involved. Indeed, where the hard evidence indicates that the court system is not up to the task, especially in terms of speed and decisiveness, a country should make it possible to commission a Fast Track Commercial Court to expedite commercial cases, which should include financial sector issues. The fast track court can, inter alia, speed up debt collection cases and resolution of disputes among the financial firms themselves. Such a fast track organization can continue until major reforms occur in the regular courts and the legal system as a whole. The ability to use land and other real estate as collateral is a major problem for financial sector development in a number of African countries. Inadequate land titling and registration and traditional land tenure systems all impose constraints on the use of real estate as collateral. Indeed, a further aspect that is ignored in general is the absence of an orderly and well-functioning real estate market, in certain African countries, even in areas where there is fee simple ownership of land. This greatly reduces the liquidity of real estate and hence its utility as collateral in the credit market. The needed reforms are really not very difficult to make.

Getting the Fundamentals Right: General Governance The overarching policy environment of a country could greatly affect the quality and performance of its financial system. Hence, given the abundance of alternatives, strong financial firms or highly talented people may not find it good for their reputation to operate or work, respectively, in a country that is considered poorly governed, or even to have close business relations with financial firms located in that country. Indeed, the ­governance of a country has wealth effects on the owners and employees of firms and organizations that are located in that country. Of particular importance, in this context, are three components of the national governance environment, namely, macroeconomic policies, socio-political governance, and the degree of compliance with relevant international standards and codes.

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Macroeconomic Policies Macroeconomic policies are important for obvious reasons. The financial system’s participants will expect these policies to affect the real rate of return on their efforts; the expected real value of their investments in the system, over time; and the ability to transfer their assets and earnings in the system from the domestic economy to another country. Thus, a financial system benefits from low inflation, stable (but legally flexible) exchange rates, capital mobility, and convertibility of the domestic currency or at least an absence of exchange controls. The manner in which the central bank uses its instruments to achieve its objectives of low inflation and financial system stability will affect the competitiveness and efficiency of the system. Among the instruments are reserve and liquidity requirements; these should not be used in ways that seriously tax banks or reduce their flexibility in using their reserves. Central bank fees and other regulations for use of payment system facilities it controls should also be no more onerous than those in leading financial centers. Moreover, capital mobility will also pose challenges. A country cannot really be a big player in the financial system business if it has stringent capital controls—inward and especially outward. At the same time, capital mobility complicates risk management for individual financial firms and could make macroeconomic management more demanding. Assuming that other governance aspects (to be discussed later) are consistently well taken care of, the basic strategy to address these complications and challenges is twofold. First is to put in a place a macroeconomic policy framework that, in general, ensures low inflation and exchange rate stability. The second is to make sure that the financial system is sound, most importantly by establishing a prudential framework appropriately designed and tailored to meet the challenge. Important elements in the quality of such a prudential system will be that (1) there should be clear understanding of risks by those who are the bearers of the risks; (2) the responsibility for managing risks in specific financial transactions should be clearly assigned; and (3) there should be appropriate incentives to those responsible for managing risks to do so in a socially efficient way (see Johnson 2002b). No matter how sound the underlying macroeconomic policy and prudential frameworks, it is doubtful that the probability of a financial crisis can be reduced to zero. Indeed, in general, the ‘financial regulation’ system cannot but be continuously reviewed and subjected to revisions, in

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light of real-world changes.18 That also means that, as part of the public policy framework, the authorities will be well advised to have measures in place to address crises when they do arise. Since the size of the financial system relative to GDP could increase with financial development (at least for some period of time), financial crises can become particularly disruptive. Hence, having a policy response fairly well thought out in advance is important. Liquidity support (typically from the central bank) and fiscal support from the government are, typically, the overarching elements of such a strategy, coordinated with emergency measures of the regulatory and supervisory authorities.19 Socio-political Governance One of the problems that policymakers in some African countries have to address is the need, effectively, to pay a premium to attract strong firms and highly talented people, when there are serious uncertainties related to political instability and the quality of economic governance in the countries concerned. Investors worry about corruption, government efficiency, maintenance of rule of law, and sustainability of policies. Strategies must therefore be developed to build credibility for political stability, low level of corruption, and other elements of good governance. When assessing countries on corruption and socio-political governance on the whole, many analysts will resort to surveys and indices purported to measure, for instance, risk of expropriation, general governance indicators, and constraints on the executive.20 Analysts will also look at the global corruption reports of Transparency International. It would seem sensible for the authorities in African countries to treat such surveys, indices, and reports with the same seriousness as they would a credit rating report. In other words, the country authorities should try and understand what go into these reports and what they can do to improve their ratings. This will help them design appropriate plans. Another part of the response strategy is, of course, to design a plan to improve general governance—with clear objectives and instruments— make it transparent, and then implement it resolutely. In designing the plan, the authorities should remember that they will need to worry about sustainability during implementation. For this reason, especially, particular attention should be paid to the deliberative process in putting the program together and the legal and organizational framework involved (see, e.g., the discussions in Johnson 2007, 2016).

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Compliance with Appropriate International Standards and Codes One of the consequences of globalization is that countries are affected, through trade and financial flows, by what other countries are doing. Hence, developments that adversely affect financial sector stability and efficiency in one country could easily spill over into other countries. In addition, countries are genuinely interested in adopting practices that have improved risk management, efficiency, and governance in other countries.21 For these reasons, countries have been cooperating in various venues and organizational settings to agree on standards and codes in a number of areas, which would be institutionalized in countries worldwide, thereby reducing the cost of enhanced cooperation in financial services, among other economic activities. The standards and codes are broad norms legitimated by the international community of market economies. They have evolved from experience and widely accepted theory; arrived at by agreement (via open discussion); and are expected to be implemented by national authorities, without a central world authority, because such implementation is in the self-interest of the countries. The self-interest of countries emanates from two basic forces: the quest for domestic financial stability and development and the desire to participate in the increasingly global and integrated system of trade and financial markets.22 In trying to develop its financial system, a country, then, must clearly demonstrate that it is resolutely implementing relevant norms—namely, basic ‘standards and codes’. Otherwise, the rating of the country’s financial firms, among peers and regulators in other countries, will tend to suffer. In such a case, the financial firms in the country will not be able to participate in important financial cooperative arrangements with financial firms abroad and the country will not be attractive to some major international financial firms and centers. In this context, certain easily observable weaknesses in the operations and ongoing development of the financial system would benefit from serious and immediate attention by policymakers. Just as a brief elaboration, these weaknesses often include the following: • Poor performance of financial institutions/organizations, resulting in recurring bank failures, as well as in low bank profitability, and low return on assets and on bank equity • High ratios of nonperforming loans to gross loans

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• Undesirably ‘low’ bank capital-asset ratios • Undesirably high riskiness of certain foreign currency exposures • Uncertain net inflows of foreign direct investment, due to poor domestic investment environment • Serious weaknesses, of national governing bodies, in financial intelligence capacity to address money laundering, illegal financial transactions, and financing of terrorism • Policymakers’ inability, in practice, to address fear of coherent approaches to monetary policy tightening (e.g., by raising the central bank’s discount rate), because of unpopular distributional effects or strong opposition in the population to central bank complete independence • Serious corruption of diverse forms, in financial firms, sometimes hard to control because powerful individuals, business firms, and organizations in the country benefit from the corruption • Having extremes of ‘high degree of concentration’ in the banking sector or ‘too many’ small banks • Failure to have developed sound measurements and indicators to know precisely the degree of financial inclusion in the country • Lack of analytical framework enabling the authorities to explain factors determining interest rates and fees charged especially by dominant banks in the country and hence, inter alia, unable to identify collusive behavior such as deliberate attempt to overcharge and/or to keep certain ‘types’ of borrowers at length • Failure to investigate and identify ways to promote saving behavior in the country • Failure to identify neglected classes of assets that could legally and culturally be promoted to serve as collateral for borrowing, in trying to increase access, to financial institutions, of small businesses and low-income individuals

Regulatory Strategy African countries, need, as a priority, high-quality regulatory environments, not only to avoid financial crises but also to help speed up financial development. There are, at least, three major consequences for financial sector development. First, a high-quality regulatory environment will have a positive effect on cooperation among firms in the financial sector, since all the firms will trust each other more than if the regulatory standards

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were suspect. Second, financial firms outside the country will look favorably on building relationships with the financial firms and markets in the country. Third, authorities in other countries will be less prone to imposing tight regulatory standards on dealings of their local financial firms and markets with financial firms and markets in the particular African country. The strategy in a high-quality regulatory environment must achieve two overriding objectives. First, it must ensure a clear understanding by regulators and financial firms of the risks faced by the financial firms and how those risks could be managed. Second, the regulatory strategy must be clear about the role of regulation versus the market in ensuring that the financial risks are efficiently managed and controlled. We should note that, in this discussion, ‘oversight’ agencies are part of the regulatory authorities. Financial Risks and Their Management Not too long ago, banking supervisors would talk about CAMEL. That acronym stands for capital adequacy, asset quality, management capability, earnings level and quality, and liquidity. There is nothing wrong with assessing a financial firm using those headings to organize one’s approach. But nowadays there is increasing feeling that explicitly organizing one’s approach to assessing the soundness of a financial firm and its management around risks and risk management is extremely important. The camel is taken care of in such an approach while bringing risks and their management more sharply into focus. In fact, it is interesting to note that for some time now supervisory authorities in a number of countries, while still using the camel approach, have transformed the CAMEL into CAMELS or CAMELOT. But then they are not quite unanimous about what the S, O, and T stand for. Sometimes the S (in CAMELS) stands for systems and control, but typically, it seems to stand for sensitivity to market risk. Similarly, the O and T in CAMELOT are sometimes for quality of operations and treasury management; otherwise, they are for operating environment and transparency. Returning to risk management, the regulatory agency or agencies of the country must ensure that the human and nonhuman capacity is there—within the regulatory community and the financial firms—to understand and manage the financial risks in the markets in which the financial firms in the country operate. An important component of the human capacity is knowledge of the analytics of risk management. Complementary resources include computers, data, libraries, and research

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budgets. Firms will have their internal processes. The regulatory agencies must set standards, sometimes in great detail, and must also oversee internal processes of firms to make sure that they are appropriate and sound. In general, many different types of risks are identified in the literature. The most important ones are liquidity, credit, interest rate, market, foreign exchange, operational, technological, sovereign, legal, and fraud (see, e.g., Penza and Basal 2001; Saunders and Cornett 2008). Regulation Versus the Market Since financial firms have an incentive to survive, it would seem that market discipline should do a satisfactory job in forcing internal processes of banks to develop and maintain sound models and processes to address risks. Indeed, financial firms should take primary responsibility for their own risk management. While accepting this perspective, a traditional response has been threefold. First is that market discipline can be effective if there is full and accurate information disclosure and transparency. Given that precondition, the more sophisticated the pool of those who could monitor the management of financial firms—such as owners, depositors, customers, and rating agencies—the more effective one would expect the forces of market discipline to be. Second, even with substantial market discipline, from a micro point of view the actions of financial firms could have certain adverse effects on third parties for which it is very difficult to structure property rights and enforcement sufficiently to ensure complete internalization of costs and benefits. Indeed, this is one motivation for the great concern with consumer protection as an element of regulation. Third, from a macro point of view, the argument is that the soundness of the financial system is essential for systemic stability and economic growth. Hence, regulators must also have important responsibilities for risk management within financial firms. One sore point about regulation, though, is the issue of standardization. Indeed, dissatisfaction with some of the regulatory initiatives has been an additional motivating force for financial firms to develop techniques and approaches that would be superior (from the perspective of firms’ risk-return profiles) to the regulatory standardized approaches (see, e.g., Crouhy et al. 1998). The tendency to put pressure on the authorities

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to permit the firms to implement their own internal processes, with only oversight by the authorities, will always be there. An optimal regulatory regime and strategy, among other things, will balance regulatory rules, supervisory review, and market discipline. Llewellyn (2002), for instance, argues that several problems emerge with a highly prescriptive approach to regulation. For example, the risks under consideration may be too complex for simple rules; prescriptive rules may prove inflexible and not sufficiently responsive to market conditions; and the rules may have perverse effects in that they are regarded as actual rather than minimum standards. He stresses that a central issue is the extent to which regulation differentiates between different banks according to their risk characteristics and their risk analysis, management, and control systems. An important theme in this framework is that regulation can never be an alternative to market discipline. On the contrary, regulation needs to reinforce, not replace, market discipline within the regime. How one determines, in practice, the balance between regulation, on the one hand, and market discipline, on the other, is bound to remain of major concern among experts. Sometimes the determination, in practice, gets influenced by balance of power of those with interests in the outcome of the game. Calomiris (2006), for example, discusses the influence of three constraints to the regulatory stance of the US Federal Reserve (Fed) during the Greenspan era: opposition by politicians, opposition by big banks, and effect on the erosion of Fed regulatory power. In this general context, it is interesting that in the final decades of the twentieth century, at the same time that the public authorities around the world were emphasizing an important role for market discipline in eliciting good governance in financial firms, those same authorities—as well as the international organizations in their standard-setting activities—were refining regulatory rules, standards, and codes. In the end, the one thing on which the experts seemed to agree was that the relative weights should indeed vary from one country to another and perhaps among types and sizes of financial firms as well, depending on the particular circumstances. Some of the determining factors, for a country, would be the available expertise within financial firms and within regulatory agencies, the nature of the risks faced by the financial firms, and the relative sophistication and efficiency of the pool of others who could monitor the management of financial firms. Our suspicion is that market versus regulation debates will continue, especially in a changing world of business and details of particular risks. Still, the basic principles guiding regulatory frameworks for some time

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now are likely to remain the same, even if the vigilance in the application of those principles intensify and certain markets and organizations that have been spared close supervision get subjected to more intensive scrutiny. Moreover, capital requirements of financial organizations will continue to be re-examined periodically. For instance, financial firms that are considered too big to fail might, for example, be constantly reviewed to be sure of the adequacy of the minimum capital they are required to hold in relation to risk-weighted assets, after adjusting for their individual circumstances. Corporate Governance If one starts with the realization that the financial organizations under consideration are, or will be, operating in developing African countries and that single failures in a financial system can have significant systemic economic effects, it is difficult to be concerned with only shareholder interests when looking at corporate governance of financial firms and markets in general. Indeed, even extending the concern to workers and other participants in the financial system is not enough. In the field of corporate governance, one could view a corporation as ‘a complex web or “nexus” of contractual relationships among the various claimants to the cash flows of the enterprise’ (Macey and O’Hara 2003, p. 92). From that perspective, the fiduciary duties of managers and directors of financial services firms should be broader than maximizing the value of the firm for shareholders. Loyalty of the organization’s officers to shareholders should not have external harmful effects on the larger community for which those shareholders do not pay. The beneficiaries of directors’ fiduciary duties (in particular, of care and loyalty) in the case of banks and other financial organizations should extend beyond shareholders.23 The requirement of fiduciary duties of senior officers of financial services firms, organizations, and markets should then hold the officers liable not so much for mistakes of judgment or wrong decisions but rather for actions and inactions that manifest fraud, illegality, gross negligence, and conflicts of interests or wrong decisions not made in good faith. It is not only shareholders who should enforce the fiduciary rules but also the supervisory authorities. In that regard, the internal supervision of financial services firms, the information reporting systems of the firms, and the decision-making processes, research facilities and

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standards of the organizations, will all be matters of supervision/oversight by the national authorities. A clear approach is thus necessary to ensure that, in exercising their fiduciary duties to shareholders, the financial services firms and markets in the financial system do not act in ways that threaten the stability of the economy or reduce confidence in the financial system as a whole. In fact, such an approach is implicit in the best supervisory regimes around the world. Such regimes contain rules, procedures, and processes designed to ensure the soundness of financial firms, including their ability to withstand shocks of reasonable probabilities. The fiduciary duties to shareholders are conditional on meeting these supervisory standards. The Compensation System and Risk Taking In the African context, it is easy to endorse an increased focus on the relationship between compensation systems and risk taking within financial firms. At the same time, it is very tempting to say that this is not a big issue in African countries in general, partly because compensation packages are not as explicitly structured in ways that encourage high-risk deals for quick profit, and partly because the kinds of bubbles that provide an environment for such deals tend to be really rare and not as bloated in the African economies as compared with more developed economies. Yet, occasionally, bank personnel in the continent do permit dangerously high concentration of exposure to a few sectors, as was the case for banking problems in Nigeria not too many years ago (see Sanusi 2009), in order to exploit what is perceived as possibilities for quick and/or certain substantial profit in the hope of being rewarded with salary hikes and other compensations (e.g., bonuses, promotion). The Financial Stability Forum (reestablished as the Financial Stability Board in April 2009), in April 2010, issued nine principles for sound ­compensation practices designed to ensure effective governance of compensation, effective alignment of compensation with prudent risk taking, and effective supervisory oversight and engagement by stakeholders (FSF 2009). The three principles dealing with effective governance are especially important. Principle 1 states: ‘The firm’s board of directors must actively oversee the compensation system’s design and operation.’ The idea is that the compensation system ‘should not be primarily controlled by the chief executive officer and management team. Relevant board members and employees must have independence and expertise in risk

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management and compensation.’ Principle 2 states: ‘The firm’s board of directors must monitor and review the compensation system to ensure the system operates as intended.’ Principle 3 states: ‘Staff engaged in financial and risk control must be independent, have appropriate authority, and be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the firm.’ Early Warning Signals Public policy toward crisis prevention and resolution has included concerted efforts to improve early warning signals and the promptness of response to crises. Policy in the area of early warning signals has at least two interrelated aspects. One is developing the ability to recognize and comprehend signals from financial firms that they are experiencing serious problems, especially liquidity and credit problems. The second involves putting in place a forward-looking risk-based supervision framework that could alert the authorities to problems arising with respect to both individual firms and a financial subsector or market. A risk-focused bank supervision framework that is forward-looking can be an important component of an early warning system (see, e.g., Baldwin 2002). Risk-focused supervision requires the supervisor to make qualitative assessments and develop a thorough understanding of a bank’s risk profile and risk management capabilities. Forward-looking and proactive, risk-focused supervision also requires flexibility in supervisory program design. The approach, in brief, involves identifying different categories of banks and then developing supervisory programs tailored to the specific needs of each category. Statutory supervisory requirements must be sufficiently flexible to accommodate such an approach. Organizational Structure: Unified or Not? It is obvious that, from an organizational perspective, a regulatory/supervisory agency must have clear objectives, autonomy, and expertise to do its job, as well as be accountable to government, parliament, financial sector/ industry, and the populace at large. Autonomy includes budgetary and instrument autonomy. Instrument autonomy includes authority and power to enforce its rules and to sanction for noncompliance, as well as immunity from prosecution of its officials for official actions taken in the line of duty.

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Most experts seem to believe that a supervisory/regulatory agency outside the central bank or the government must be funded by levy on the regulated firms and markets, rather than by government. Having said that, there is nothing, in principle, to prevent a country from deciding to wholly or partially finance an independent supervisory agency from general government revenue if, in light of the rudimentary state of the financial sector, levies from that sector are insufficient to maintain a supervisory agency of a sufficiently high standard. An important issue is whether there should be a unified supervisory agency or instead one should adopt various models of dual or multiple agency arrangements (see, e.g., Abrams and Taylor 2000 for some discussion). A disaggregated approach to supervision could work well, even for a country trying to develop its financial system from a low base. In addition, the country, for historical reasons, may feel comfortable with a non-­ unified approach. For perhaps the majority of the African countries, it would seem reasonable that a single, unified agency would have several advantages that are important for an accelerated development of their financial systems. First, there would be efficiency gains—economies of scale in regulatory activity— in the form of savings on administration, infrastructure, data collection, and management24; absence of a need for modalities to share information and establish cooperative committees and the like with other agencies; efficient use of highly trained and experienced experts in short supply coupled with the ability to pay them well and hence to retain them in the public sector; ability to finance continuous training of staff in-house or externally; and externalities in knowledge and information sharing among staff of varied expertise in close proximity to each other (clustering effect). Second, it makes sense to encourage financial conglomerates25 and, for these, unified supervision is advantageous; overall risk assessment for the whole enterprise is important, because problems in one area will spill over to other areas. Third, products across subsectors are becoming more and more similar and hence directly competitive; regulatory neutrality can be better attained with unified supervision. Fourth, there will be little or no risk of financial services falling in-between the cracks due to lack of clarity of supervision authority in a dynamic financial services environment; foreign regulators will have to deal with only one supervisory agency, and the accountability problem is simplified as everyone will know the agency that is responsible for the supervision of the financial services industry and hence for any lapse or mistake. Finally, the gains from clustering and

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accessing global value chains will be better appreciated, and hence facilitated, by a single unified regulator. There are, of course, certain risks and challenges that will confront a unified agency. First of all, there will be a challenge to balance the multiple objectives of a unified supervisory agency. But surely, these objectives would all revolve around risk management, efficiency, consumer protection, and corporate governance issues. Second, possible diseconomies may arise. One frequently mentioned is that politicians and policymakers may be tempted to assign the unified agency functions that are outside its core domain. Another is that the unified agency may become somewhat inefficient due to its monopoly status. But clearly the direct solutions to these problems are not difficult to find. Third, it may be challenging to create a single agency culture, since the mindset of supervisors of different types of specialized financial firms and markets often appears to differ. Still, countries with unified agencies in place have been well aware of this problem and have found solutions for it. None of this, in our view, prevents some African countries from copying the Twin Peaks approach of South Africa, with a single Prudential Authority and a Financial Sector Conduct Authority. The Prudential Authority, even though autonomous, could be housed in the central bank if the country prefers this. The Role of the Central Bank Under a Unified Structure Even where there is unified supervision of financial services, by an agency separate from the central bank, the central bank must ensure that it has up-to-date prudential information on the banks. The central bank needs the prudential information in connection with its conduct of monetary policy, its foreign exchange rate policy and management, its lender of last-­ resort function, and other elements of its role in the payment system. In each of these areas of activity, banks will be the primary, and sometimes the only, set of financial services firms with which the central bank will be directly dealing. Apart from direct contacts with banks, in the unified structure the central bank should in any event maintain close contact with the financial services supervisor. That way, the central bank can obtain additional insight from the financial services supervisor on the state of particular banks, as necessary. Ireland has been a good example of the close cooperation between the financial sector supervisor and the central bank (see O’Sullivan and Kennedy 2008; CBFSA of Ireland 2010).

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Tiered Regulation of Financial Institutions Financial institutions, especially banks, are often regulated in Tiers according to asset size, especially in major countries. In the United States, for example, large banks have more frequent bank examinations (i.e., shorter cycles) than smaller banks; smaller banks are subject to pressure for lower incentive compensations for their top management; and stress testing requirements are stricter—basically shorter time cycle spans—for the big banks. In general, banks considered ‘systemically important’ are subject to more rigorous prudential regulations than non-systemically important banks. In such a context, the concept of enhanced supervision is one that the supervision authorities have to clarify and detail its description. Apart from the above, items like requirements for liquidity ratios, and for specification of the precise strategy for orderly resolution in case of financial distress, usually differ depending on bank size and classification with regard to systemic importance. In brief, it makes sense for most African countries, as the financial system expands, to begin the process of explicitly classifying, especially, regular commercial banks according to levels of systemic importance. In addition, the relevant authorities should formulate clear regulatory frameworks to ensure that the nature and strictness of regulatory requirements correlate positively with the potential systemic costs of failure of any given financial institution. In order to make the system rational and easy to understand, it makes sense to copy the idea of classification of financial institutions into a fixed number of ‘Levels’ or ‘Classes’ or ‘Tiers’, from the perspective of systemic importance, make clear the different elements or criteria being used as inputs and the weight being ascribed to each criterion, in determining the overall classification of each institution. After all this is done, it makes sense also to make transparent the nature of the regulatory and supervisory requirements that will differ among the ‘Levels’ or ‘Classes’ of the financial institutions.

Major Policy Areas of Focus in the Financial Market Development Process A developed financial system will have certain architectural and organizational structures that are particularly well-functioning. Indeed, it is the high quality of such structures and their functioning that make a financial system developed, as opposed to being underdeveloped or rudimentary.

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This means that, from a policy point of view, financial market development can be seen as finding a socially optimal way to put such structures in place and have them well-functioning. The important questions include: where should the focus be over the next decade or two in a country trying to seriously advance the development of its financial system and what are the appropriate roles of the public sector and the private sector? Moreover, what should be the nature of cooperation between the private and the public sectors? In such a context, selective intervention policies should be carefully thought through: in particular, financial markets should generally be given freedom and space to evolve and expand. Clearly, in the early stages of a major effort in financial market development, attention needs to be paid to certain important elements and aspects of the money market, the payment system, and capital market. Money Market Development An active money market benefits the central bank (in its monetary policy decisions and operations), the government (in its budget finance operations), as well as portfolio managers, banks, and securities markets. Hence, serious attention needs to be paid to its evolution and major development. Indeed, as regards monetary policy, problems and shocks relevant to monetary policy formulation are revealed more quickly the more developed are money markets, as they show up in market variables such as interest rates; the monetary transmission process is also smoother, and with shorter lags, the more integrated and efficient are money markets. An active, liquid, integrated, and efficient national money market contributes to enabling open market and other central bank operations to influence interest rates, base money, bank free reserves, or any other targets of monetary policy. Government instruments to finance deficits will also see increased demand and hence lower interest rates, other things being equal, the more developed are money markets. Moreover, with well-developed money markets, low-risk instruments become available to portfolio managers and banks, and hence diversification and intermediation are made easier, with ultimate benefit to saving and investment as the gains are passed on to potential savers and investors. For money market development, the building blocks and enabling environment are well known. To facilitate the evolution of well-­functioning and active markets in financial products, the authorities need to take

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resolute steps to ensure certain desirable qualities of the environment. These relate to the legal framework, the clearing and settlement systems, the efficiency of the banking system, macroeconomic stability, as well as credit rating systems. Ideally, well-functioning and efficient credit rating organizations would also be desirable. Since these are not likely to emerge in some African countries for some time, banks should be encouraged to further develop their own internal credit rating systems. These, no doubt, will vary in sophistication from one bank to another. High-quality central bank data will also provide some of the information that the banks would need. In particular, the financial system would benefit from specialized credit rating organizations. The authorities could promote the emergence of such organizations, including helping to identify sources of technical assistance. The authorities should also ensure that the credit rating organizations maintain an appropriate balance between confidentiality and accessibility to lenders and investors of the raw data and information collected and the credit ratings themselves. The money market in a country will evolve along several different lines depending on the preferences of the participants. The products of a developed well-functioning money market could be standardized (typically by maturities) or non-standardized. Non-standardized products have irregular maturities and, in some countries, irregular settlement procedures as well. They can also have specific securities as collaterals, for example, repos with liquidity provided against specific bonds. The organization of the market differs in detail among countries, even with well-functioning money markets. The relative importance of market makers (who take positions, quote two-way interest rates) and of brokers (who do not take up positions) also differ widely from place to place. Generally, in well-functioning markets, trading via brokers is small (around 10–20 percent); the rest is done on a bilateral basis. The nature of the trading also differs (role of electronic screens, bilateral direct contacts via telephones, the use of correspondent accounts with major banks, and more). Foreign exchange swaps tend to be quoted in terms of an exchange-rate premium/deduction, and not directly as an interest rate. The premium, of course, will tend to reflect interest rate parity calculations. In general, there are deposit and short-term funds, bond repos, securities with short remaining maturities, private sector money market assets, and swaps.

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Deposits are the cornerstone of the interbank market. This is normally a market for unsecured overnight funds. The associated credit risks could be enormous. A secondary market in prime assets (an asset-based market), in contrast, facilitates interbank transactions across the maturity spectrum and avoids the credit risk problem, whether by outright sales of paper, collateralized deposits, or repurchase agreements. As part of its role in the market, the central bank may help determine the standards that banks need to satisfy to be allowed to participate; it may help in developing an electronic trading system to use; and it could insist on specifying the maturities and the limits (e.g., in relation to deposits or capital) to prevent excessive borrowing or short-term borrowing becoming long-term. The interbank market itself can be important for monetary operations and policy. The interbank rates can serve as benchmarks for fixing interest rates for other financial products and could be the major operating targets of monetary policy. Private sector money market assets, such as bankers’ acceptances (BAs),26 certificates of deposits (CDs),27 or commercial paper28 could be useful in the development of the money market. But they could differ greatly in credit risks and the authorities may have little or no control over their supply. Discounting them can be a challenge for the central bank. For BAs, there are typically two names at least, the endorsing bank and the accepting bank; hence the credit risk is typically lower. The CD is a ‘one name’ paper, the name of the issuer, as is the commercial paper. A central bank can have substantial leverage over the money market, because it could decide standards to participate in any open market operations, to come to its discount window, and to settle in its books. The central bank can take several direct steps to assist in the development of the money market. Perhaps the most important role the central bank could play is the provision of settlement services for the banks. That way, they do not have to use correspondent banking arrangements and will settle using balances with zero credit risk and achieve settlement finality with payment, once their accounts have been credited and debited in the books of the central bank. The central bank can also be important in market information, practices, and architecture. In other words, it can encourage certain practices and procedures, and its persuasive powers are enhanced by the fact that it could intermediate and foster cooperation among market participants, at the early stages of market development. The central bank could encourage

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the emergence of market makers and market maker agreements, for instance by having special financing facilities for market makers and requiring signing of market-maker agreement(s) in the various products for access to the financing facilities. The central bank could also encourage up-to-date computerization. Moreover, the central bank could collect, collate, and disseminate information (mainly aggregated and with short-time lag of a week to a month) to market participants on things like positions, transactions volume, financing, bids, and offers. The central bank should also see that the market participants set standards on matters like delivery and payment, no doubt with the purpose of early achievement—that is, as soon as possible—of delivery versus payment on the books of the central bank. Important issues arise with respect to discount window policy and reserve requirement policy. There is a delicate balance to be struck with respect to access of banks to borrowing from the central bank at the discount window. The central bank cannot encourage the use of its discount window as a first resort; the banks should be encouraged to go to the market. The central bank could even help by having a ‘discount window’ that is effectively selling one bank’s excess to another bank with a demand for reserves, for example, for settlement purposes in the books of the central bank. In other words, the central bank could be operating an interbank market for, say, overnight funds. To encourage banks to continue to first look to the interbank market, as that market develops, a central bank could lend at only penalty rates, sometimes even backed by securities (so-called Lombard facility). The central bank could, alternatively, lend at non-penalty rates with rules of access that discourage overuse. The central bank could influence the composition of the products in the money market, for example, via the instruments selected for open market operations or discounting. For instance, if over time there comes to be only limited stocks of government treasury bills for public debt purposes, a decision would need to be made regarding whether the central bank would issue its own bills, whether the government would agree to have a special issue of bills to be employed for monetary policy purposes only, or whether the central bank would agree to using short-term private debt instruments (including interbank products) in its monetary operations. In the case of private debt instruments, the central bank selects among the market papers available, taking into account especially credit risk, and this has an unavoidable impact on the product structure of the interbank market.

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All things considered, even starting from a low level of financial sector development, a country that has substantial ability (including organizational ability) could rapidly develop its money markets, particularly by focusing on the evolution of bonds, bankers’ acceptances, commercial paper, and bond repos. Banks could issue certificates of deposits (CDs), and large nonfinancial firms could issue commercial paper and bankers’ acceptances (BAs). These instruments could soon begin to be regularly traded in financial markets. The central bank should set capital requirements for accepting banks in the case of BAs. The right to issue CDs and accept bills of exchange/time draft could be restricted to sound banks declared safe and well run by the banking supervision department of the central bank. Given limited trust for banks by potential depositors, credit risk fears of some market participants, and the expected initial absence of a sizable and active market for CDs, banks may, for some time, be able to attract participation only in CDs of short duration say three, six, and nine months. After some experience with those maturities, additional and longer maturities could be successfully issued. Banks could also be permitted to sell bonds. Bonds would normally be of longer duration than CDs, say three to five years to start. In the current environment of some countries, banks may need to take specific measures to increase the attractiveness of the bonds. Until an active secondary market for them emerges, the issuing banks could stand ready to repurchase the bonds on demand, with discount rates closely tied to some indicator rate. The discount factor, of course, would differ with the term to maturity of a bond. A disadvantage of the policy of commitment to repurchase the bond is that banks may lose the assurance of the medium- to long-term nature of the loan involved in a bond issue; they may, therefore, feel constrained from using the funds to make medium- to long-term loans. While this is understandable, the enhanced liquidity of the bond due to the policy may encourage the development of a secondary market in the bonds, so that the issuing banks in fact are never called upon to repurchase the bonds before maturity. In addition to standing ready to repurchase outright their own bonds, banks could also be willing to arrange repo agreements involving their own or other banks’ bonds. Payment System Development Many African countries have rather rudimentary payment systems. Desirable for efficient and well-functioning financial markets would be at

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least one large value payment system that satisfies the 10 core principles for systemically important payment systems (see Committee on Payments and Settlement Systems (CPSS) 2001). The central bank would no doubt own and manage this system. Settlement among domestic banks for all financial market transactions would also take place in the books of the central bank. The central bank must, unavoidably, address a number of organizational issues as it strives to lead the modernization process and develop the payment system.29 An African country with a payment system that needs serious modernization should find it useful to set up a National Payments Council (NPC), comprising at least the central bank and a number of commercial banks, and probably also other financial organizations that actively participate in the payment system. Within such a coordination body, ideas can be openly discussed, information on demand for payment services obtained, and a consensus reached on important public policy issues related to institutions (including the legal framework), competition policy, and the role of the central bank, as well as technological and other choices for major (especially large value) systems (e.g., types of payment instruments, queuing mechanisms, availability and pricing of intraday liquidity, overnight credit, availability of information to participants, and time of settlement finality) and risk control measures such as the use of collateral and backup and contingency plans (see Johnson et  al. 1998). Support from the NPC can indeed greatly enhance cooperation, at the implementation stage of major initiatives, thereby lowering implementation costs. A major challenge the authorities will face is deciding how the payment system should evolve with the demand (basically user requirements) of the financial system, given limited resources on the one hand and the desire to foster economic growth and development on the other (see, e.g., Johnson et al. 1998; CPSS 2006). A well-developed depository system for securities should complement the development of the clearing and settlement system. Moving quickly to dematerialized securities and making sure that the speed of settlement of stock transactions meets international standards would also help the development of the capital market (discussed later). Capital Market Development and Economic Growth Empirical evidence clearly shows that Stock Markets have had positive effects on economic growth, worldwide and in African countries as well

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(see, e.g., Boadu et al. 2016; Boubakari and Jin 2010; Levine and Zervos 1998; Mohtadi and Agarwal 2016; Ngare et al. 2014; Yartey and Adjasi 2009).30 This is not surprising. From growth theory we know the importance of investment and the marginal efficiency of investment as factors affecting economic growth (see, e.g., Johnson 2016, pp.  7–8); both of those determinants, in turn, are positively affected by stock market activity. In that context, for a country starting, or significantly expanding, its stock market, the positive effect on growth would be further enhanced if the stock market is able to motivate an increase in the country’s domestic saving and capital inflow into the country from abroad. This also means that the positive effect of stock market on economic growth would be greater the sounder is the economic policymaking environment of the country. Thus, for African countries, introducing, expanding, or ‘modernizing’ stock market(s), would be an important element in any strategy designed to facilitate economic diversification and growth (see, e.g., Johnson 2016). Among other things, stock markets could greatly help to widen the access of entrepreneurs to investment resources, to enhance the ability of households and businesses of all sizes and resources to invest otherwise idle resources, and to encourage businesses to improve corporate governance so as to attract investors via a potentially well-run and credible organization as the stock market. African countries should, of course, not allow pushing stock market development to divert them from pressing on with development of their banking systems.31 Indeed, the banks themselves will be able to raise equity in the stock market and the stock market will benefit from the screening capabilities and securitization activities of banks. Hence, there could be an effective coevolution of two important branches of the financial system (see, e.g., the model of Song and Thakor 2010). All of this should have a positive effect on economic growth. When countries institute a Stock Exchange, they typically would establish a Securities and Exchange Commission (SEC) as well, even if with some time lag. Apart from trying to get the stock market functioning in a regular way and putting in place the rules (particularly relating to capital adequacy of brokers and ensuring disclosure and investor protection) and the machinery to make the SEC perform its functions effectively, the country authorities in the typical African country would have the SEC help develop and deepen the capital market, as a whole, via this stock exchange avenue.

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The SEC in a country may monitor the growth of the ratio of ‘value of shares traded per period’ relative to ‘gross domestic product’ (GDP). If such a ratio is low by some standard chosen (e.g., relative to other selected countries), the SEC could work with the stock market to find out the cause of the slow growth and thereby help find a way to improve the stock market performance. For many African countries, stock market capitalization and liquidity32 will perhaps not be very significant for some foreseeable future. At the same time, the running and management costs may be burdensome, for reasons including costs related to automation of trading and setting up a central depository system. Some of these African countries could benefit from multi-country integration of such exchanges, if possible, somewhat along the lines of Bourse Regional Des Valeurs Mobilière (BRVM), the regional Stock Exchange involving eight French-speaking West African countries of the West African Economic and Monetary Union (see, e.g., Yartey and Adjasi 2009). This approach could indeed become an element in the regional economic integration of the African countries (see, e.g., Johnson 2016). To ensure that a stock market contributes effectively to financial development and economic growth of a country, the authorities, as a minimum, could take steps (organizational, institutional, and market developmental) to ensure substantial growth in listing on the market. Otherwise, as the evidence shows, the stock market will help large firms raise capital but the direct contribution of the stock market to economic growth will be very small and probably even insignificant; in addition, the stock market could remain underdeveloped for a long time (see, e.g., Yartey and Adjasi 2009).33 To help it grow, the regular stock market in an African country could be structured in such a way that firms/companies are able to sell stocks to very low-income individuals, via brokers, typically, and hence enable small firms, even by African standards, to list in the market. Surely, it is possible, in a particular African country, to come up with an innovative framework and operational arrangements that enable the listing of such small companies. African countries’ stock markets need not stop at simply copying the institutional and organizational practices of the world’s leading stock markets. As part of the attempt to significantly raise the level of capital market development, serious technical assistance may be useful to potential entrepreneurs, to modernize their operations. Domestic firms could then

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provide the incentives for venture capitalists to enter a budding capital market and for banks to increase seriously their portfolio of long-term loans. The modernized enterprises would be able to issue equity and bonds for which there would be effective demand from regular savers and investors. Various aid agencies and nongovernmental organizations could assist commercial enterprises, in a country with clear evidence of its undertaking to modernize. African countries’ activities seeking such assistance make sense because, if there is a sound economic policy environment in a country (see Johnson 2004) and hence good prospect for sustainable growth in the 6–10 percent range, for a couple of decades at least, modern companies worldwide will undoubtedly be attracted to being some of the drivers of the country’s growth process. In brief, they will become important channels via which foreign direct investment flows into the country. The development of a secondary bond market may also need early attention in a financial development program implementation. Promotion of some kind of bond market association as found useful in some countries (e.g., Republic of South Africa) is a logical way to begin. This may evolve into a Bond Exchange, as in South Africa (see Mboweni 2006); some other arrangements may be equally satisfactory in different contexts. Capital market development is likely to be helped in its progress, if investment banking is encouraged and promoted by countries that do not yet have much of this activity occurring at the present time. Of course, investment bankers (corporate financial advisers) are not going to emerge significantly, as separate entities, if there is not substantial demand for their activities. Indeed, investment bankers really emerge in significant numbers as stock markets and corporations issuing stocks and bonds locally emerge and are growing in significant size and volumes. The investment bankers in their activities would, essentially, be advising their clients—the corporations and the governments—in ways to raise money. As the economy becomes more developed, the investment bankers, as seen in developed and many developing countries, would also help in other finance activities such as arranging mergers and acquisitions and organizing bond issues and other finance-raising activities by large firms and local governments, all in line with law and with public authorities’ regulations. In time, as African countries develop and diversify their economies, investment bankers can underwrite some major securities’ issues, which would take the financial system to another level, including syndication. The challenge for policymakers in a country is finding a way to begin this particular financial market development process and consciously guide it to maturity. A few

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countries, including South Africa, have already begun the investment banking process; indeed, quite a fair number of African countries can, rather soon, no doubt be able to sustain significant investment banking activities at a reasonable cost-benefit ratio.

Financial Inclusion Available evidence indicates that the banking sectors in Africa have been, in general, doing well in the recent past, particularly since 2010, in terms of market growth and return on equity, when compared with the rest of the world. Indeed, the banking sectors in Africa seem, on average, to have been recently experiencing high growth and profitability (see, e.g., Chirunga et al. 2018).34 As elements of the success, African countries, for instance, have been experiencing increased bank deposit accounts and number of bank loans per one thousand adults. On the whole, banking growth is thus having positive effects on economic growth and poverty reduction in the bulk of these countries. The hope among many policymakers is that innovations in ‘normal’ banking practices and procedures, on which a few African banks are working—for example, cooperation with cellphone networks and so-called digital banking35—can become more widespread (especially because of price and convenience, given service) and help to foster even more ­significant increases in financial inclusion of the African populations that cannot afford traditional banking services, for various reasons, including service charges, minimum balance requirements, and distance. The incentives to traditional financial institutions to participate in such innovations seem to be there and are becoming even more attractive. Financial inclusion is all about available means of access to financial services, at affordable cost, of potential beneficiaries who are at the low ends of the business and consumer populations. The evidence is that such inclusion matters for economic growth, reduction in poverty and inequality, as well as macroeconomic policy effectiveness (see, e.g., IMF 2018). Policymakers in African countries have, therefore, to be concerned about (1) the adequacy of access to bank saving, payment, and credit facilities for low-income and rural persons (individuals and enterprises), and (2) access to credit for all persons in different types of activities outside of commerce, especially medium- and long-term borrowers in agriculture and industry. While progress in financial inclusion is of great value to the society, it does not mean that government and central bank policymakers should design

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policies directed at private financial institutions to bolster certain types of inclusion, irrespective of the cost and benefit to the private institutions. Being aware of this, countries find themselves joggling between (1) creating an incentive environment in which financial institutions themselves find it profitable to act in ways that gradually but continuously enhance financial inclusion36 and (2) putting in place official measures (controls, directives, and incentives) that together compensate financial institutions for having to obey policies (official controls and orders) promoting financial inclusion designed and monitored by the national authorities. Of course, there are countries that try to find ways to combine the above two sets of approaches. From a developmental perspective, the above challenge is a reaction to the fear that the way financial markets work in many low-income countries has resulted in (i) a deviation of private and social profitability in the allocation of credit; (ii) adverse effects on small-scale entrepreneurship; and (iii) overall suboptimal financial intermediation that has deterred saving mobilization for development in many poor countries. The disappointment here is that in certain places (see, e.g., World Bank 2017), wide access of low-income persons to a wide range of financial services enables them to significantly raise their welfare.37 In particular, access to financial services enables the low-income persons to speedily transfer payments at low cost they can afford, as well as to obtain credit and insurance to run businesses, weather financial shocks, and invest in education and health. The view that available funds for lending may be suboptimally allocated by free open markets has also led many policymakers, for a long time, to believe that one solution or remedy to ensure ‘fairness’ in access to credit could be selective credit controls. Unfortunately, such controls were seen to have serious adverse welfare and economic growth effects and considered rather indirect attempts to solve the underlying problems (see Johnson 1974, 1975). Johnson (1974), for example, argued that to address the underlying problems a direct solution could simply be explicit tax-cum-­subsidy or the creation of financial firms with actual or potential comparative advantage in assessing the creditworthiness of, and in administering and servicing loans to, what we can call here the ‘neglected borrowers’. This second approach is based on the view that high administrative cost and the fear of high default rates, in light of adverse selection and/or moral hazard, are seen as important reasons why certain borrowers are neglected by the regular financial firms.

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Unfortunately, high-quality credit rating agencies covering the whole economy do not exist in most African countries to help banks in the client screening process, for instance. Moreover, internal rating systems of the banks are not typically designed—in light of profitability considerations—to help solve the screening and monitoring problems related to lending to micro borrowers, for example. The informal financial sectors in virtually all African countries have a long history of functioning at levels that do not provide financial services (especially credit) to support sizable business operations. In addition, the degree of trust required in their modes of operations limit the depth of financial commitment that individuals may want to risk in operations such as rotating savings and credit associations (ROSCAs). Hence, especially from the perspective of operations such as saving and credit related to low-­income individuals and businesses, African countries face major challenges of which they have been aware for many decades and are continuously trying to innovate or refine their approaches to create institutional and organizational arrangements to improve the situation; the main ultimate motivation is the desire to improve access to credit of ‘neglected’ individuals and enterprises. More recently, African policymakers have also seen that even making payments can be a burden to the low income and hence have supported initiatives to lighten that burden as well. Mobile Money It has become clear that financial inclusion cannot be left only to traditional deposit banks, despite their central position in the financial inclusion process. Indeed, so-called mobile money has greatly enabled financial inclusion with a significant welfare benefit to low-income populations; thus, it has attracted the attention of policymakers, investors, aid agencies, and researchers. ‘Mobile money’ enables individuals and businesses to use their mobile phones to deposit, transfer, and withdraw funds from some organization or agency without necessarily owning a traditional bank account. The system is also easy to use and has no minimum deposit requirement. In certain African countries, the evidence is that mobile money has substantial positive benefits, especially for low-income populations, and hence significantly contributes to reducing poverty and raising economic growth in those countries. Studies of the factors affecting the spread of mobile networks indicate that of major importance have been

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the regulatory framework, the density and quality of agent networks, and the reliability of a country’s mobile phone network (see Suri 2017 for an excellent discussion of the mobile money literature).38 Many African countries now have some form of mobile money. Even banks are benefitting by not having to have physical branches all over a country to provide essential banking services throughout that country; indeed, apart from the digitalization of the mobile banking process, the possibility of ‘agent’ banking has made branch banking less needed throughout a country for certain basic banking services to be efficiently provided at low cost. Financial inclusion rates have substantially increased in all countries that have been able to establish well-functioning mobile banking and money systems. Mobile money saving, payments, and transfers have indeed attracted attention not only within the African continent but also outside by organizations (private and international) that could actively assist in accelerating the development of mobile money and also agent ‘banking’ (see, e.g., Carey 2016; International Finance Corporation 2018a, b).39 Moreover, governments have also begun to think of digital government bond issues. For instance, in March 2017, the Kenyan Treasury launched a pilot version of a digital government bond issue named M-Akiba (see Suri 2017, p. 516). The Kenyan authorities intended to ensure that the bonds would always yield positive real returns for the savers involved. To realize the enormous positive impact on economic growth and welfare of citizens (especially poverty reduction), much oversight is needed to ensure that mobile transaction fees are ‘fair’, especially when serious competition is lacking; that the importance of high level of inventory management of cash and e-money is recognized; and, also, that direct measures are in place to prevent thefts by company agents. Thus, for efficiency of the mobile money system, it is important that policymakers ensure high standards of individual agent’s expertise, integrity, and transparency, as well as serious competition in the ‘agency market’ (see also Suri 2017). At the same time, the regulatory system should not be unnecessarily burdensome or restrictive (particularly with respect to agents, user requirements, and fees) and thereby hinder the spread of the system. Clearly, serious policy focus at the national level is inevitable for good results as in the case of all activities requiring serious standards and oversight as well as fairly sophisticated infrastructure.

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Mobile money in its present form is, we believe, likely to reach its maximum usage soon and begin to decline over time as African countries develop economically and, as a consequence, bank accounts and credit cards become affordable for, and available to, increasing percentage of the residents of those countries. Electronic (internet) transfers using bank accounts and credit cards, as well as telephone and mobile phone payments using credit cards, will all be among the methods that replace so-­ called ‘mobile money’ in its present forms. The speed of evolution of this process is hard to predict. Community Banks African countries, like other countries around the world, want to get their adult citizens, as a minimum, to participate in commercial banking, in one or more ways—as depositors, savers, borrowers, and/or shareholders. Hence, some African countries struggle with ideas of why, how, and when to actively promote community banks, including so-called village banks of certain forms (see, e.g., Mashigo and Kabir 2016), in addition to encouraging greater commercial (regular) bank branching, and increasing the ability of all such banks to lend to certain currently ‘neglected’ groups. A concern, in this process, is that it is still much easier for low-income persons to get access to deposit and saving accounts than to loan accounts. The problem, of course, is generally because of the risks and servicing costs associated with managing credit to very lowincome groups. In general, a community bank would tend to have significant representation of persons native to the community concerned at the ownership, management, and clientele levels of the bank. The bank would, of course, be legally independent as an organization and may not have branches outside of the particular community concerned. The regulatory and supervisory authorities would no doubt have separate requirements for such banks—such as capital adequacy—from the requirements of the big systemically important banks. This, of course, is not a necessary requirement, but rather an attempt to be less stringent, perhaps because the authorities feel that bank failures at that community level are not likely to have adverse systemic effects. An important downside of the value of community banks, unfortunately, is that even though such community banks are designed for ‘local

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persons’,—namely, local ‘human beings’ and ‘businesses’—they are not typically accessible to ‘poor’ persons. In addition, important potential clients of the banks may not even realize that the community banks can be fully capable of satisfying their needs; hence, despite the community banks’ proximity to major potential clients, the bulk of such potential clients may ignore the community banks and simply approach the well-known national banks to satisfy their needs. Community banks, thus, often need to advertise their strength and focus, on the community, in their attempts to find ways to convince their potential clients of the completeness and quality of their banking services at costs lower than those of the major national banks. In big countries, like the United States, the idea of community banks is to give greater attention to the demand (‘needs’) of local communities— individuals and businesses. Community banks (sometimes simply called ‘local banks’) are expected to channel deposits, obtained mainly from the local community, into loans in the communities involved. The bank officers are also supposedly highly accessible to the community depositors and borrowers and, in principle, are immersed in the local affairs of their communities. In making decisions on loans, for example, personal characteristics of the borrowers are likely to be considered, not excluding family history. One advantage often cited for such banks is that they understand the ‘needs’ and ‘constraints’ of small businesses, being small businesses themselves. Community banks in a country like the United States can, of course, be big relative to some commercial banks in some African countries. Indeed, the commercial banks in many African countries are likely to behave like community banks in extending loans and in their relationships with their communities (which are not really the ‘small communities’ in their countries). In any event, if ‘community banks’, in the traditional sense, are emerging in an African country, the relevant authorities in the country could explore ways to encourage regular commercial banks to acquire significant share-holdings in the so-called community banks. The national authorities could also find ways to promote sound community banking, focusing initially on fairly well-populated regions of the country, away from the major cities, not already well-served by the regular commercial banks and their branches, and yet the potential for economic transformation is palpably obvious and could be realized with

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sound national policymaking.40 In general, of course, the authorities would need to ensure that the community banks are regulated and supervised in the same coherent manner as with regular banks, especially to ensure that the community banks are adequately capitalized (including having adequate capital buffers, to ensure that they can survive certain significantly probable major shocks), and that they have well-trained and well-qualified staff.41 Member-Based ‘Banking’ Organizations There are several types of formal legal organizations, based in countries around the world, where the ‘owners’ and ‘board members’ are also mainly the ‘depositors’, ‘savers’, and ‘borrowers’. Popular names for these organizations are credit unions, savings and loan associations, building societies, village banks, and mutual banks. The analytic framework of the regulatory and supervisory controls on these organizations can be made somewhat similar to those of regular banks but the standards to be met are not typically as stringent, mainly because of their lower systemic importance. The challenge to the regulators and supervisors of the financial system is how to ensure high-quality management of such organizations, while allowing them appropriate flexibility to address the diverse ‘needs’ of their owners, members, and clients. Credit unions, savings and loan associations, and building societies should probably be left to organizations and groups that are dominated by relatively educated and middle- to high-income individuals. At the same time, African countries trying to bring into the regular banking business (as depositors, savers, and borrowers) the low-income households, such as those that dominate mobile money transacting, can do so partly by promoting village banks and mutual banks. The cultural experience of rotating savings and credit associations (ROSCAs), all over the continent, should make the educational effort involved relatively easy (see also Coetzee and Cross 2001). Apart from promotion efforts and broad education of the populace involved, there would also be need, in many of the African countries, for appropriate legal, regulatory, and supervisory framework for the mutual and village banking system(s), to ensure their financial soundness and stability while meeting the ‘needs’ of the members of the organizations.

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Microcredit Microfinance firms and organizations are surely, even if slowly, expanding in African countries, and increasingly benefitting small farmers and other enterprises, while the lenders are reaping positive rewards. Mali, for instance, has been highlighted as one of the countries where this success story is noticeable, especially following an ‘experiment’ in the form of an innovative loan to farmers that led to a significant increase in investment ‘on agricultural inputs such as fertilizer, herbicides and insecticides’, resulting in a significant increase in agricultural output (quantity and value) as well as value of livestock (see Tayal 2018). Other African countries are, of course, also benefitting from sound microfinance lending projects (see, e.g., Nijiraini 2015). The most important issues are how such ‘experiments’ should be financed and operated, what should be the measurement of their ‘success’, and what are likely to be the evolutionary processes that follow. At the moment, the view is, of course, that by increasing access to credit for certain groups and activities, especially farming and various other small-scale activities, microcredit organizations have been very successful, inter alia, by enabling entrepreneurship among the low-income population and augmenting the saving rates in some poor communities. The enormous research that has been ongoing in the microcredit area has provided evidence that group lending, which had seemed like the preferable way to lend to the poor, to enable group enforcement of obligations, may not be as essential as once thought. Collateral-free individual liability lending has worked under several schemes. Also, experience has revealed ways to address problems with group lending—most notably strategic default leaving others to bear the repayment obligation—where such lending continues to be found essential. The structuring of incentives—for example, a gradual increase in lending ceilings, threats to cut off credit for repayment failures, varying interest charged with repayment record—have been experimented with in several locations around the developing world (see, e.g., Karlan and Morduch 2010 for a review and some references). At the same time that all of this is going on, there is also a case for addressing the general question of the role of microcredit in poverty alleviation and national economic growth. No doubt, an important issue in these investigations would be if it is possible to ensure viability of microcredit

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programs without subsidies and financial aid. On the face of it, the answer seems to be ‘yes’, given the successes of many microfinance institutions in the continent. These, logically and in essence, are like small-scale financial institutions. What needs to be done is to make sure that such organizations are subjected to official oversight. Microcredit activities do not need to be confined only to agriculture. Other areas that benefit the poor if they have access to credit include general education, technical and vocational education and training, as well as access to certain health services. This would be especially the case when citizens have to contribute, privately and significantly, to many of these services (for discussions of some of the issues involved, see, e.g., Armendáriz de Aghion and Morduch 2005; Banerjee and Duflo 2010; Khandker 1998; Yunus 1999). Long-Term Regular Bank Finance for Small and Medium Non-micro Enterprises The measures to improve the enabling environment for financial firms, by getting the fundamentals right, as well as to develop the capital markets, discussed earlier, would all help to increase access to long-term investment funds, including bank long-term loans. There is also a need to look at specific problem areas that many have highlighted as relevant in some countries, namely, the system of land rights, several collateral issues, as well as transparency in pricing and in the procedures of the banks. Beyond those, in order to improve policymaking in this general area of long-term investment funds for the medium- and small-scale enterprises in the private sector, in a number of African countries there is still need to clarify certain major issues. These would include the following topics: • The available evidence that finance is a significant constraint on entrepreneurship among small and medium enterprises (SMEs) • The nature and potential sources of funds currently available to SMEs • The type of actions that SME entrepreneurs can, and should, take to gain increased access to potential funds, given their capacity to use the funds, especially by making sure that their default risk is not higher than that of the larger enterprises • The lending costs per dollar of loans to SMEs and micro enterprises

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Addressing such issues would help in designing appropriate public policy (via especially by the government, the central bank, and the legal system) not only to further improve the enabling environment, so as to attract suppliers of funds that could be loaned to the appropriate investors, but also to enhance the capacity of the local entrepreneurs to independently attract and profitably use such funds. Traditional Saving Facilities for the Lowest Income Individuals and Groups Although the preoccupation of access to finance, for the so-called underserved, in most African countries, has emphasized credit, it is useful to keep in mind that the supply of instruments, mechanisms, and products for financial saving, as well as the supply of insurance services, are also elements of access to finance that are important to financial development and to economic growth in general, which it can be argued are not optimally available in most African countries. Here, again, the low-income and rural populations are the most underserved. Policymakers in African countries know that low-income individuals are capable of saving and do save. In general, they save via cash held in their homes, including in foreign exchange; deposits made with trusted persons, typically more well-to-do relatives and friends; investments in nonfinancial assets like cattle, land, residential buildings, and jewelry; and miscellaneous business assets, which they use in commerce as well as in other businesses they operate, such as tailoring or taxi service. When these are the only saving outlets, the savers can typically benefit from greater flexibility, liquidity, and diversity in their savings portfolios. Indeed, from a national point of view, this also means that national investment may not be as efficient as it can possibly be and the return to national savings may not be as high as feasible. In sum, even the national saving rate may not be as high as it possibly can. In that context, African countries that have national social security and insurance systems—such as the National Social Security and Insurance Trust (NASSIT) in Sierra Leone—can open them to their informal sectors. Indeed, a number of countries do seem to want to design and effectively market financial sector products that can attract savings of the poor into the financial system (see, e.g., Consultative Group to Assist the Poor (CGAP) 2010; World Savings Bank Institute (WSBI) 2004, 2008).

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A successful initiative of years past, in some British colonies, was the Post Office Savings Bank (POSB). It was especially important for residents in the rural areas. In today’s world, when many of those post office savings banks have disappeared, or practically inactive even though alive officially, the Tanzania Postal Bank (see World Savings Bank Institute (WSBI) 2004, 2008), has, inter alia, even profitably entered the microcredit business, with the saving and credit components complementing each other. In that kind of environment, some minimal saving requirement could be a qualification for obtaining a loan, whether individually or as a member of a microcredit group. With literacy rates increasing and general educational levels rising among the poor, it should become easier even for commercial banks to design and build up flexible saving accounts in the population as a whole. These accounts could earn market-competitive interest, and hence superior to traditional passbook accounts. Such accounts, as with certain saving accounts already in existence, could allow withdrawals after minimal notice. In order to market such accounts, apart from finding ways to spread the information, innovations like using deposit collectors, mimicking what informal saving arrangements do, can be efficient, especially in the larger towns. In many African countries, following tradition, to attract the savers from smaller towns and villages, the deposit collectors can arrange periodic meetings with depositors (say once a month or two) in public places such as Community Centers. The challenge would be to find inexpensive ways for savers to withdraw funds to meet urgent unexpected needs; indeed, accessibility to savings accounts at all times is an important incentive contributing to success in savings drives directed at low-income individuals and groups. The availability and increasing use of cell phones (and hence ‘mobile money’) could play a part in such drives in the immediate future. The government and banks, but not other private firms, in the near future, could also be allowed to issue bearer (coupon) bonds. The bonds maintain anonymity with respect to the holder to whom interest and principal will be paid upon tendering a bond certificate; hence, they do run the risk of loss due to theft, misplacement, or destruction. But unlike cash they earn an interest. In the early stages, an innovative bank could offer safe deposit facilities for especially low-income persons residing in certain neighborhoods. The government could also consider issuing a small savers security to be purchased on tap. The security could be of various maturities, cashable

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before maturity but not transferable, and hence avoiding the risk of forgery that can be quite substantial for a bearer instrument. The interest rate on this security should at least match that of regular government securities of similar or close maturities.

Insurance African countries know very well that sound insurance industries are important for the financial sectors and that they should make sure that the industries are as strong as feasible. Hence, they should strengthen their overarching Insurance Acts, making sure to incorporate microinsurance and crop insurance. Insurance supervisory authorities should also be strengthened, using advice and consultations from the international community. The governments and financial sector authorities of the African countries are also advised to work closely with their local Insurance Associations, as well as with the major individual firms/ companies operating in their countries in strengthening the Insurance Acts. Ways should also be found to make the industry better serve the public including via requiring insurance companies to maintain complaint registers and to formalize insurer redress mechanisms that work in the public interest. African countries could do more to increase the demand for insurance, in their countries, particularly for health, housing, and life. In many of the countries, there may be a need to study ways in which the insurance market could be expanded, including the appropriate insurance product designs for various types of potential clients/demanders. Indeed, insurance facilities and products for the lowest income individuals and groups, which are no doubt very hard to design and manage and for which the effective demand, prima facie, is especially low, will need special attention in such a study. Poor households in many countries in Africa do face a variety of risks from shocks that can have serious adverse long-term consequences for their well-being. There are traditional devices that the poor use to address these risks. In farming, for example, multi-crop farming is one. Generally, mutual and communal assistance arrangements, especially to deal with adversities like illnesses, bereavement, and crop failures, are also forms of insurance. Still, there is a potential effective demand from the formal insurance market, which should not be neglected ex ante.

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Notes 1. In that context, as well as in the context of the functioning of the financial system in general, see, e.g., Č ihák et al. (2012). 2. The 2017 Financial Sector Regulation Act of the Republic of South Africa is an example of the awareness of a number of the African countries of the need to reassess and modify, continuously, elements of the financial system’s governance structure; systemic fundamentals, including so-called ‘prudential quality’ to ensure its continuous adaptation to changing domestic and global conditions and thereby ensure appropriate market and prudential behavior of individual financial institutions, as well as stability, development, and growth of the financial system as a whole. The Act calls for establishing a Prudential Authority and a Financial Sector Conduct Authority, which will have regulatory powers over the entire financial sector, and also confers powers on the Reserve Bank to enable it to preserve and enhance financial stability. The Act fosters coordination, cooperation, collaboration, and consultation among the Reserve Bank, the Prudential Authority, the Financial Sector Conduct Authority, the National Credit Regulator, the Financial Intelligence Centre, and other organs of state, in addressing financial stability issues. The Act, moreover, suggests a Financial System Council of Regulators, a Financial Sector Inter-Ministerial Council, and a Financial Services Tribunal to act as an independent tribunal inter alia with powers to reconsider decisions by financial regulators and the Ombud Council. 3. See, for example, IMF (2016) and other references below. 4. See, e.g., Johnson (2016), pp. 18–20. 5. See, also Agyemang et al. (2018). 6. In South Africa, for example, the emphasis on the second and third concerns (prudential regulations and financial inclusion) have led to the country’s formal adoption of what some call the Twin Peaks approach to financial sector regulation and supervision. For example, since 2016, South Africa now has a Prudential Authority doing the traditional supervision work (housed within the South African Reserve Bank), and a Financial Sector Conduct Authority (a market conduct regulator) that does the other tasks, with the two bodies coordinating with each other. The Twin Peaks approach can vary from country to country using different criteria. For example, systemic risk levels could be used to subdivide financial institutions into two sets, each set being supervised by a separate authority; each authority could then also be concerned with the financial conduct of its own set of ­institutions. Other possible approaches to these details are, of course, quite possible, depending on the history and experience of countries.

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7. The European Investment Bank does a regular analysis of banking in Sub-­ Saharan Africa. See, for example, European Investment Bank (2016). 8. See https://www.theglobaleconomy.com/rankings/Stock_market_capitalization/, where Mauritius and Morocco tend to be ranked within the first 30 countries. South Africa seems stable within the top three to five countries. 9. BRVM is the stock exchange for Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo. It is located in Abidjan, but there are market offices in each country. 10. Still, periodically, banks find it difficult to maintain buffers adequate enough to deal with certain serious shocks especially when they result from poor management and internal malpractices. For instance, a Nigerian bank, Skye Bank, which ran into serious trouble, because of bad loans and insider malpractices, was accused of failing to have enough capital buffers to absorb bad losses; this led to the central bank’s dismissal of the management and replacement with a new management team, in July 2016. 11. Adelson (2012), in a Standard & Poor’s article, along this line, succinctly characterized the ‘true role’ of credit ratings in the financial system as being there ‘to help close the information gap between lenders and borrowers by providing independent opinions of credit worthiness’. 12. Anthony Saunders (1999) classified the traditional approaches into expert systems, rating systems, and credit scoring systems. In the first, expert systems, the credit decision is made by the local lending officer who typically makes recommendations to some loan committee. The officer in making a recommendation must take into account the so-called five Cs of credit, namely, character, capacity, capital, collateral, and cyclical or economic conditions. This approach is criticized for not ensuring consistency and objectivity across clients, offices, and types of borrower. Rating systems could vary enormously. Banks’ internal rating systems differ in sophistication, depending on the data available (quantity and quality), the training and skills of the staff of the firm, and other resources (computers, libraries, and research budgets) devoted to the effort (see, e.g., Stephen and Fischer 2002). The models seek to foster consistency, transparency, and objectivity in credit ratings. The effort involves building databases, benchmarking, constant review, and back testing. The models use financial and market data, sector-specific information (data and variables), and qualitative information. In decision making on rating grades, they estimate probability of default and loss given default (and hence expected loss from a loan to a counterparty), as well as migration potential, which is the probability that the credit rating of the counterparty will change to some other rating grade (e.g., AAA, Aa, A, Baa, Ba, B, Caa-C) from one period to another. The objective of credit scoring systems is to identify important variables affect-

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ing the probability of default and weighting them into a score. Thus, the credit scoring system can be used as an element in the rating system. Indeed, with adequate data, one can fit a model for default probability as a function of several variables and then use the coefficients as weights in determining credit scores. 13. See, e.g., Financial Intelligence Center Amendment Act of South Africa (2017). 14. See, e.g., Sierra Leone (2009). 15. See, e.g., Nelson (1993) and several papers in Oyelaran-Oyeyinka and McCormick (2007). 16. Capital mobility has a positive impact on financial market development: among other things, it improves the menu of investment outlets available to suppliers of funds while users of funds have access to cheaper and more sophisticated financing, and so it expands the opportunities for portfolio diversification. At the same time, capital mobility complicates risk management for individual financial firms, makes macroeconomic management more challenging, and fosters financial integration, which increases the risk of cross-border contagion (see, e.g., Sundararajan et al. 2002). In order to address the complications, two fundamental policy responses have been found useful. First, the macroeconomic policy framework (most notably monetary and exchange policies) must be appropriately designed and tailored to meet the circumstances. Second, a strong prudential framework should be developed to help ensure a sound financial sector with a high standard of risk management (see Sundararajan et al. 2002). 17. A similar point has been made by Sanyal (2007) in the context of Mumbai. 18. See, for example, Tarullo (2019). 19. See Välilä (2002) for a discussion of the basic analytical issues involved in considering fiscal support. 20. Risk of expropriation comprises survey indicators of institutional quality from the International Country Risk Guide. The data include subjective assessments of risk for international investors along such dimensions as law and order, bureaucratic quality, political corruption, risk of expropriation by the government, risk of government contract repudiation, and overall maintenance of the rule of law. The governance indicators of the World Bank currently comprise six dimensions: voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. The constraints on the executive measures come from Polity IV data set (Polity IV Project). The aim is to measure directly the limits of executive power. Constraints on the executive refer to the extent of institutionalized constraints on the decisionmaking powers of chief executives. The concern is with the checks and

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balances between and among the various parties in the decision-making process. 21. In Ghana, for example, Asembri (1996) was proud of the high standards for listing and trading that the young Stock Exchange of Ghana had set as confirmed by a visiting team from the Commonwealth Secretariat in October 1992. 22. See Johnson (2002a), who makes these points in the case of the compliance with the Core Principles for Systemically Important Payment Systems. 23. Macey and O’Hara (2003) also take a view that is along this line when discussing the corporate governance of banks. They would like ‘bank directors to expand the scope of their fiduciary duties beyond shareholders to include creditors’ (p. 92). Hence, they ‘call on bank directors to take solvency risk explicitly and systematically into account when making decisions, or else face personal liability for failure to do so’ (p. 92). 24. Michael Foot (2005), for example, notes that before the Financial Services Authority (FSA) in the United Kingdom, there were eight different ‘principal’ regulators. They ‘all had support services for Information Services and Human Resources that were seriously sub-optimal in size. It proved also much easier and more effective for the FSA to represent UK interests in Brussels and at the huge range of international regulatory meetings than it had been for the individual regulators’. The FSA has been recently replaced by two separate regulatory authorities, namely, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), the former independent and the latter an arm of the Bank of England. 25. Fear of conflict of interest, insider trading, and domination and abuse are, of course, risks that should be addressed in this regard. Conglomerates are also more complex to supervise than financial firms operating in only one subsector, because the risks, consumer protection, creditor protection, and corporate governance issues differ in significant details across subsectors. 26. Banker’s acceptance is a bill of exchange or time draft drawn on and accepted by a bank. The bill of exchange itself is a two-name paper, the drawer and the drawee. 27. A negotiable claim issued by a bank in return for a term deposit. 28. An unsecured note issued by companies for borrowing (typically on short term). 29. Of interest here is the speech by Tommaso Padoa-Schioppa (2004). 30. Levine and Zervos (1998), in particular (p. 538), ‘find that stock market liquidity—as measured both by the value of stock trading relative to the size of the market and by the value of trading relative to the size of the economy—is positively and significantly correlated with current and future rates of

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economic growth, capital accumulation, and productivity growth. Stock market liquidity is a robust predictor of real per capita gross domestic product (GDP) growth, physical capital growth, and productivity growth after controlling for initial income, initial investment in education, political stability, fiscal policy, openness to trade, macroeconomic stability, and the forward-­looking nature of stock prices’. 31. See, for example, the papers in Demirgüç-Kunt and Levine (2001). 32. Two measures of liquidity found useful are as follows: (1) the value traded ratio, that is, the total value of shares traded on a country’s stock exchanges divided by GDP; and (2) the turnover ratio, that is, the total value of shares traded on a country’s stock exchanges divided by stock market capitalization (the value of listed shares on the country’s exchanges). The turnover ratio measures trading relative to the size of the market. Levine (1997), in addition, notes that trading costs and the degree of uncertainty associated with trading and settling transactions are also important in assessing liquidity. He further explains that the objective of the liquidity indicators is ‘to measure the degree to which agents can cheaply, quickly, and confidently trade ownership claims of a large percentage of the economy’s productive technologies’. 33. The evidence is that the contribution of the stock market to economic growth becomes significant after some threshold of the ratio of value of shares traded to GDP is crossed. In other words, stock market liquidity matters greatly for the contribution of stock markets to economic growth in general. As indicated by the Ghana Alternative (Stock) Market (GAX), it is also possible to design certain stock markets to enable small- and medium-­sized enterprises to use them to raise funds (see Bortey 2013). Of course, even regular stock markets could be designed to encourage SMEs to participate. 34. That study, among other things, identified four ‘archetypes’ among African banking markets, significantly different in per capita income, banking penetration, revenue growth, profitability, and financial infrastructure. Differences among the archetypes are significant in areas like ‘share of retail banking in revenue’, ‘bank penetration’ (branches for any given population size), ‘sophistication of financial services’ (such as asset management and mortgage), and participation in ‘mobile banking’ services. Very interesting is the identification of countries they call ‘sleeping giants’, which are countries with large markets in which banking penetration is lower than would be expected, given their income levels, and which are all oil exporters. Apparently, the focus on the oil economy distracts banks in those countries from the rest of the economy, in their banking activities.

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35. Digital banking does not always mean full digitization of all of a bank’s activities, programs, and functions. For instance, Kenya’s Commercial Bank of Africa (CBA) is cooperating with Safaricom, a cellphone network, to create a low-cost phone-based service for small loans and payments. In this context, see also the discussion on mobile money below. On digital banking and aspects of its current nature and scope of use in African countries, see the discussion in Chirunga et al. 36. In this light, it is interesting that, using data of Sub-Saharan African countries, Mengistu and Perez-Saiz (2018) find a positive and significant effect of competition in the financial sector on financial inclusion (in particular, access to bank accounts, credit and debit cards, and bank loans). 37. Malaysia is, perhaps, the most proactive country, in recent decades, in monitoring and promoting financial inclusion. The country’s authorities even introduced a Financial Inclusion Index, which uses as its dimensions, ‘Convenient accessibility’, ‘Take-up rate’ (% of adults), ‘Responsible usage’ (% of customers), and ‘Satisfaction level’ (% of customers). Each dimension has one to three indicators. For instance, the indicators for ‘Take-up rate’ are for deposit accounts, financing accounts, and life insurance (see World Bank (2017), pp. 32–33) and thus measure the population’s usage of specific financial services. The procedure enables the authorities to get a sense of ‘progress’ among different segments of the population, especially income groups. 38. As Suri puts it: ‘Mobile money is an App in the true sense of the word because it operates via software that is installed on a SIM card, although it is typically run on regular phones rather than smartphones’ (Suri 2017, p. 498). 39. IFC and the Mastercard Foundation, for instance, launched, in 2012, a 7-year program—the Partnership for Financial Inclusion—to expand microfinance and advance digital financial services in Sub-Saharan Africa (see IFC 2018a, b). While in operation, the main objectives of the partnership will be to mobilize new digital financial services users and new banking agents. They also will do research that would help guide policymaking and private sector activities. For instance, an early research conducted by the partnership showed that it was about 25 percent less costly to expand services through an agent network than through traditional bank branches (IFC 2018a, p. 2). The Partnership is also supported by the Development Bank of Austria and the Bill & Melinda Gates Foundation, and collaborates with knowledge partners such as the World Bank and CGAP (Consultative Group to Assist the Poor) (IFC 2018b). 40. In many African countries, ‘regular’ commercial banks can hardly be found in major farming areas or small mining and semi-industrial towns. Even when such banks are in those areas, they are not typically full-service; in

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particular, they will rarely be in the business of assessing credit worthiness of locals or extending substantial loans to them. Yet, community banks could develop tremendous comparative lending advantage in such areas, which could be extremely valuable for a well-governed African country trying to accelerate its economic transformation. 41. The regulatory authorities in Tanzania, for instance, in 2017–2018, had to close about five of their dozen community banks because of ‘critical undercapitalization’ of these banks (see, e.g., Reuters 2018).

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Demirgüç-Kunt, Asli, and Ross Levine (editors), 2001, Financial Structure and Economic Growth: A Cross-Country Comparison of Banks, Markets, and Development (Cambridge, MA: MIT Press). ——— (editors), 2008, “Finance, Financial Sector Policies, and Long-Run Growth,” Working Paper, no. 11, Commission on Growth and Development. European Investment Bank, 2016, Banking in Sub-Saharan Africa, Recent Trends and Digital Financial Inclusion. http://www.eib.org/attachments/efs/ economic_report_banking_africa_digital_financial_inclusion_en.pdf. Financial Conduct Authority, https://www.fca.org.uk/. Financial Stability Forum (FSF), 2009, FSF Principles for Sound Compensation Practices, April. http://www.financialstabilityboard.org/. Foot, Michael, 2005, “Restructuring UK Financial Supervision—The UK Experience,” in Central Bank Modernisation, edited by Neil Courtis and Peter Nicholl (Central Banking Publications). HM Treasury, 2007, “Financial Capability: The Government’s Long-Term Approach” (London: HM Treasury), January. International Finance Corporation, 2018a, “Mobile Money Offers Africans a Financial Future.” https://www.ifc.org/wps/wcm/connect/news_ext_content/ifc_external_corporate_site/news+and+events/news/impact-stories/ mobile-money-africa. ———, 2018b, “Expanding Microfinance and Advancing Digital Financial Services in Sub-Saharan Africa.” https://www.ifc.org/wps/wcm/connect/ region_ext_content/ifc_external_corporate_site/sub-saharan+africa/priorities/financial+inclusion/za_ifc_partnership_financial-inclusion. International Monetary Fund (IMF), 2016, Financial Development in Sub-­ Saharan Africa, Promoting Inclusive and Sustainable Growth, IMF Staff Team led by Montfort Mlachila. https://www.imf.org/en/Publications/ Departmental-Papers-Policy-Papers/Issues/2016/12/31/. ———, 2018, Financial Inclusion in Asia-Pacific. https://www.imf.org/en/ Publications/Departmental-Papers-Policy-Papers/Issues/2018/09/18/ Financial-Inclusion-in-Asia-Pacific-46115. Johnson, Omotunde E. G., 1974, “Credit Controls as Instruments of Development Policy in the Light of Economic Theory,” Journal of Money Credit and Banking, Vol. 6, no. 1 (February), pp. 85–99. ———, 1975, “Direct Credit Controls in a Development Context: The Case of African Countries,” in Government Credit Allocation: Where Do We Go from Here? (San Francisco: Institute for Contemporary Studies), pp. 151–180. ———, 2002a, “Compliance with the Core Principles for Systematically Important Payment Systems and the Role of the IMF,” in E-money and Payment Systems Review, edited by Robert Pringle and Matthew Robinson (London: Central Banking Publications), pp. 203–214.

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———, 2002b, “Comment, on ‘On the Welfare Costs of Systemic Risk, Financial Instability, and Financial Crises’,” in Financial Risks, Stability, and Globalization, edited by Omotunde E. G. Johnson (Washington, DC: International Monetary Fund), pp. 229–238. ———, 2004, “How Will Good Economic Policy Environments Emerge in Africa?” Journal of Policy Reform, Vol. 7, no. 3 (September), pp. 151–164. ———, 2007, African Economic Development: Cooperation, Ownership, and Leadership (Lewiston, NY: The Edwin Mellen Press). ———, 2016, Economic Diversification and Growth in Africa: Critical Policy Making Issues (Palgrave Macmillan). Johnson, Omotunde E. G., Richard Abrams, Jean-Marc Destresse, Tonny Lybek, Nicholas Roberts, and Mark Swinburne, 1998, Payment Systems, Monetary Policy, and the Role of the Central Bank (Washington, DC: International Monetary Fund). Karlan, Dean, and Jonathan Morduch, 2010, “Access to Finance,” in Handbook of Development Economics, Vol. 5 (Oxford: North Holland), pp. 4703–4784. Khandker, Shahidur R., 1998, Fighting Poverty with Microcredit: Experience in Bangladesh (Oxford University Press for the World Bank). Levine, Ross, 1997, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35, no. 2 (June), pp. 688–726. Levine, Ross, and Sara Zervos, 1998, “Stock Markets, Banks, and Economic Growth,” American Economic Review, Vol. 88, no. 3 (June), pp. 537–558. Llewellyn, David T., 2002, “Alternative Approaches to Regulation and Corporate Governance in Financial Firms,” in Financial Risks, Stability, and Globalization, edited by Omotunde E. G. Johnson (Washington, DC: International Monetary Fund), pp. 117–163. Macey, Jonathan R., and Maureen O’Hara, 2003, “The Corporate Governance of Banks,” FRBNY Economic Policy Review, February, pp. 91–107. Mashigo, Polly, and Humayun Kabir, (2016), “Village banks: A Financial Strategy for Developing the South African Poor Household,” Bank and Bank Systems, Vol. 11, no. 2, pp.  8–13. https://www.businessperspectives.org/journals/ banks-and-bank-systems/issue-190/village-banks-a-financial-strategy-fordeveloping-the-south-african-poor-households. Mboweni, T. T., 2006, “Deepening Capital Markets: The Case of South Africa,” Speech at the Seminar on “Deepening Financial Sectors in Africa: Experiences and Policy Options,” co-organized and co-sponsored by the IMF/AFR and DFID (Johannesburg), November. http://www.reservebank.co.za/internet/ Publication.nsf/LADV/590E9E23E07AC8B34225721F003B90DE/$File/ IMF-capital+markets-7+nov06a.pdf. Mengistu, Azanaw, and Hector Perez-Saiz, 2018, “Financial Inclusion and Bank Competition in Sub-Saharan Africa,” IMF Working Paper, WP/18/256.

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Mohtadi, Hamid, and Sumit Agarwal, 2016, “Stock Market development and Economic Growth: Evidence from Developing Countries.” https://cpb-usw2.wpmucdn.com/people.uwm.edu/dist/0/252/files/2016/07/PA1-401-xuvkfs.pdf. Nelson, Richard R. (editor), 1993, National Innovation Systems: A Comparative Analysis (New York and Oxford: Oxford University Press). Ngare, Everlyne, Esman M.  Nyamongo, and Roseline N.  Misati, 2014, “Stock Market Development and Economic Growth in Africa,” Journal of Economics and Business, Vol. 74 (July–August), pp. 24–39. Nijiraini, John, 2015, “Microfinance: Good for the Poor?” https://www.un.org/ africarenewal/magazine/august-2015/microfinance-good-poor. Nso, Maurice Ayuketang, 2018, “Impact of Technology on E-Banking: Cameroon Perspectives,” International Journal of Advanced Networking and Application, Vol. 9, no. 6, pp. 3645–3653. O’Sullivan, K. P. V., and Tom Kennedy, 2008, “Supervision of the Irish Banking System: A Critical Perspective,” CESifo DICE Report, 3/2008, pp. 20–26. Oyelaran-Oyeyinka, Banji, and Dorothy McCormick (editors), 2007, Industrial Clusters and Innovation Systems in Africa (Tokyo, New York and Paris: United Nations University Press). Padoa-Schioppa, Tommaso, 2004, “Shaping the Payment System: A Central Bank’s Role,” Speech delivered at the Bank of Korea’s Conference on Payment Systems, 13 May 2004. https://www.ecb.europa.eu/press/key/date/2004/ html/sp040513_1.en.html. Penza, Pietro, and Vipul K. Basal, 2001, Measuring Market Risk with Value at Risk (New York: John Wiley & Sons, Inc). Prudential Regulatory Authority, https://www.bankofengland.co.uk/ prudential-regulation. Reuters, 2018, “Tanzania Shuts 5 Small Community Banks to Protect Financial Stability.” https://www.reuters.com/article/tanzania-banks/tanzania-shuts5-small-community-banks-to-protect-financial-stability-idUSL8N1OZ1C2. Sanusi, Lamido, 2009, “Development in the Banking System in Nigeria,” August 14. http://www.cenbank.org/out/speeches/2009/Govadd-14-8-09.pdf. Sanyal, Sanjeev, 2007, “Building an International Financial Center in Mumbai,” Asia Economics Special, Deutsche Bank, Global Markets Research, June 15. Saunders, Anthony, 1999, Credit Risk Management: New Approaches to Value at Risk and Other Paradigms (John Wiley & Sons, Inc.). Saunders, Anthony, and Marcia Millon Cornett, 2008, Financial Institutions Management: A Risk Management Approach (Boston: McGraw-Hill). Shin, Yongseok, 2018, “Finance and Economic Development in the Very Long Run: A Review Essay,” Journal of Economic Literature, Vol. 56 (December), pp. 1577–1586.

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Yartey, Charles Amo, and Charles Komla Adjasi, 2009, “Stock Market Development in Sub-Saharan Africa: Critical Issues and Challenges,” International Monetary Fund Working Paper, WP/07/09, August. Yunus, Mohammed, 1999, Banker to the Poor: Micro-Lending and the Battle against World Poverty (New York: Public Affairs).

CHAPTER 3

Establishing Socially Efficient Foreign Exchange Markets

Abstract  African countries should aim for social efficiency of their foreign exchange (forex) markets, inter alia, to ensure that the foreign exchange systems are sound from the economic growth perspective and fair from a distributional perspective. In any African country, the policymakers of the government and the central bank should agree on a macroeconomic policy framework and the central bank should develop a governance structure for the forex market, with monitoring rules and enforcement mechanisms to ensure sound operations of a unified foreign exchange market. The central bank, in its intervention in the forex market, should not distort the openness and fairness of private foreign exchange market operations. Interventions by the central bank in the foreign exchange market can succeed in smoothing the path of the exchange rate and in stabilizing the rate, both of which may be of value to the welfare of the citizens under certain circumstances. Still, in the context of a coherent financial market development policymaking, a freely floating socially efficient forex regime could be found and not difficult to manage. In policymaking and implementation, the relevant authorities should address certain behavioral factors that have been identified in the economics literature and ensure a high degree of coordination between monetary and fiscal policies. Keywords  Socially efficient market equilibrium • Exchange rate regime • Net foreign asset • Behavioral economics • Menu effects • High-­ powered money • Selective intervention • National social welfare © The Author(s) 2020 O. E. G. Johnson, Financial Sector Development in African Countries, https://doi.org/10.1007/978-3-030-32938-9_3

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Introduction Foreign exchange (holdings of money and highly liquid assets denominated in leading international currencies) is extremely important for the typical African country. This is simply because the typical African country depends on imports of many important goods and services for its domestic production and consumption but its own domestic currency has very limited acceptability (as a medium of exchange) in international transactions. As a result, the typical African country, for the bulk of its imports, needs to pay with a few internationally accepted (major) foreign currencies, obtained via exports, capital inflow, borrowing, and grants. This also means that, in general, for economic efficiency and welfare maximization, and hence social welfare of the citizens, the typical African country can benefit from a well-developed and socially efficient domestic foreign exchange market. In other words, for welfare maximization, the foreign exchange market should be operating in such a way that economic growth of the country and the social welfare of its citizens cannot be improved merely by changing the foreign exchange market structure, operations, and management, other things being equal. This social efficiency objective is a major challenge for African countries. If there is social efficiency, not only will the foreign exchange market be efficient in a technical sense, but also the individuals and firms that operate in, and interact with, the market will consider its operations sound and fair whether from a growth or a distributional perspective. Whatever social efficiency is achieved by the foreign exchange (forex) market is the outcome of (1) governance, namely, implementation of rules/laws and regulations established and enforced by the relevant country authorities; (2) systemic fundamentals put in place at the national economic policy level to ensure appropriate (social welfaremaximizing) macroeconomic policy environment and microeconomic incentive systems; and (3) socially optimal selective intervention, of the central bank and/or the government, in the foreign exchange market. The forex market itself will comprise both private and public sector organizations. Organizations of the public sector (including government) and private bodies are expected to establish, implement, and enforce the rules.

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Social Efficiency A desirable policy objective is having a macroeconomic regime such that, other things being given, the equilibrium exchange rate maximizes real per capita income, via its effects on imports, exports, and net capital inflows. To ensure socially efficient market equilibrium, purchases and sales of forex should be at prices and quantities that are freely determined by buyers and sellers in open competitive markets. Indeed, with appropriate systemic fundamentals and governance, a macroeconomic regime that allows free inflows and outflows of forex earnings and payments, including capital inflows and outflows, should enable a socially efficient forex market to emerge. Such a socially efficient forex market promotes individual welfare maximization of market participants, given their individual budget constraints. There are actions by the central bank (and the government as well) that can hinder the attainment of social efficiency of the foreign exchange market of a country. First, there is market intervention by the central bank, in an otherwise free private forex market, which could prevent social optimality. Such central bank intervention typically involves two general types of actions. One action by the central bank is fixing exchange rates (buying and selling rates) that the private banking sector must use in forex transactions with the nonbanking sector. These fixed rates are often not open market clearing rates; sometimes they are, in fact, deliberately multiple buying and selling rates that result in multiple/segmented markets rather than a unified forex market. Such an approach ignores the fact that fixing of the exchange rate by decree cannot normally promote social efficiency; price flexibility in truly open well-functioning markets is one way in which adjustment takes place to ensure continuous social efficiency of the exchange rate. In addition, if the authorities believe that the distribution of forex by the market is ‘inefficient’, from an official growth and social welfare perspective, there are superior alternative mechanisms (from a social welfare perspective) via which those concerns could be addressed. Such mechanisms typically involve subsidies and taxes on individuals’ and firms’ income and wealth, rather than direct price and quantitative controls on forex buying and selling. A second type of intervention is central bank posting buying and selling rates for and from its own portfolio of foreign currencies, and deciding when and how much to buy and sell and from which sellers and/or

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buyers. This approach can work well, even from a welfare perspective, especially if the objective of the central bank is to help stabilize the rate during periods of panic and uncertainty and if the window of the central bank is open to all financial institutions that operate in the regular forex market of the country. Social efficiency of the forex regime cannot really be satisfactorily assessed by looking at the relationship between the choice of forex regime and (i) economic growth, (ii) inflation and/or (iii) balance of payments (BoP), of a country over some period of time. The welfare gains and losses to economic agents in the society, from the operations of an exchange rate regime, cannot be assessed without taking into account the welfare effects on individuals and firms. In this context, we would argue that the decision-making on foreign exchange rate regime choice and management, including the role of private markets, the central bank, and the government, should be guided by the four overriding principles stated below. 1. For any commodity or service (including foreign currencies), the authorities—government and/or central bank in this case—should not try to control directly the allocation or the price of that commodity or service, unless the government or the central bank, as the case may be, happens to be the sole buyer and/or the sole seller of the commodity or service. 2. In the management of the macroeconomy, the role of the government, the central bank, and the private markets should evolve over time as the financial system (including especially the private foreign exchange market) develops. Such a process should be pursued resolutely by the authorities, to enable, as soon as possible, the central bank to focus on monetary policy (and inflation control) and the government to focus on fiscal policy (and hence economic development and growth), leaving to open and well-functioning private markets the allocation of foreign exchange to private users. If the authorities want to subsidize the foreign exchange demand of a certain sector or economic group, they should use direct, transparent, and socially efficient subsidization approaches to implement such a policy. For instance, the government authorities (not the central bank) can buy the foreign exchange from the open market (while strictly observing its own budget constraint) and resell it at lower price(s) to groups it wants to subsidize.

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3. To ensure speedy and efficient emergence of a free and open foreign exchange market, rapid and coherent development of the financial system as a whole should be a major objective of the government and the central bank. 4. The central bank in its own buying and selling of foreign exchange should design, and strictly follow, rules that are transparent and operate in ways that do not have distortionary effects on the operations of the private forex market, including the determination of the exchange rate. The last principle, inter alia, means that if, for some reason, the central bank wants the exchange rate of some major currency to be maintained at a certain level, then the central bank should not do so by fiat (or control), but rather by buying and selling the appropriate currency in the private foreign exchange market. Alternatively, of course, the central bank can use other (indirect but economically sound) policies (in particular inflation management), to affect the exchange rate of the domestic currency. Thus, we believe it is best for the typical African country to strive for a macroeconomic governance regime with (1) an independent central bank that is in charge of monetary policy, (2) strictly enforced official rules that allow freedom of capital mobility, (3) a flexible exchange rate regime with a free and open forex market, and (4) official interventions, in the forex market, by the central bank, that involve open buying and selling of forex, and dealing with officially licensed and regulated financial institutions. Some economists have been interested in finding out, empirically, whether exchange rate regimes in countries worldwide have had significant effects on the most important macroeconomic performance variables, namely, inflation and growth (see, e.g., Ghosh et al. 2002; Stotsky et al. 2012). In reality, no clear analytical conclusions have emerged from such analyses. A conclusion that could be drawn from such studies is that a country can work well with any exchange rate regime (i.e., a certain set of rules, processes, and organization determining its exchange rate level and variability) depending on its socio-political national governance environment (again the rules, processes, and organization in that area). Thus, there should be focus on the bottom line, namely, a need for macroeconomic policy coherence to ensure optimal (or satisfactory) inflation and growth. In every African country, it is possible to describe the actual operational (real world) forex regime by specifying (1) the actual role of three major

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‘governing powers’ in the system, namely the private forex market, the central bank, and the government; and (2) the relative power of identifiable socio-political forces in the population of the country that pressure for specific methods of implementation of certain governance rules in the foreign exchange market. In just about every African country, simple classifications like ‘fixed’, ‘flexible’, or ‘pegged’ will not be strictly correct, if one looks closely at the implementation. At a minimum, words synonymous with ‘managed’ or ‘limited’ will have to come in somewhere in the objective classification. Whatever the official classification, there are no clear rules or fixed formulas such that by entering information from the real world, the policy outcome can be immediately forecast. To make matters worse, the relative strength of the various socio-economic-political forces joggling for power over the detailed operational regime choice tend to change continuously. In a strictly free market economy, one would leave foreign exchange rate determination to a well-organized and competitive private market, combined with occasional transparent open-market interventions by the central bank, with clear objectives such as reducing the variance of movement of the exchange rate, especially during periods of serious economic, social, or political uncertainty or turmoil. In such a context, the rationale is that the soundness of economic governance of the country is generally enhanced when the central bank focuses on inflation and the foreign exchange rate determination is normally left to a unified, open, and competitive forex market. Those who favor this approach would argue that the determination of the exchange rate and the allocation of the available foreign exchange should be left to an open competitive market, governed by institutional and organizational conditions that are not difficult to design. Moreover, according to this view, such a governance approach promotes economic efficiency and growth, and hence social efficiency. From this perspective, a government that wants to address certain particular social welfare objectives can use other direct and more appropriate instruments that do not distort the functioning of markets, including especially the foreign exchange market. Another area of interest to some economists is comparing the growth and inflation of countries having multiple exchange rate systems (MERS) with growth and inflation of countries that have unified exchange rate markets. But MERS is a purely distributional instrument; it is not really an instrument to address economic growth and inflation. It is also almost impossible to prove that MERS aggravates inflation and low growth. The

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control variables are likely to be very complex. In any event, there is no need for that exercise. MERS is a distributional instrument (for both consumption and production goods) to achieve certain objectives of the country’s policymakers. A more convincing approach to addressing this issue is to find out the nature of the objectives of the policymakers and suggest alternative direct approaches that do not result in distortions of markets. Simultaneously, policies should be designed and implemented to address the major macroeconomic problems, namely economic growth and inflation. The overall forward-looking argument to the policymakers would thus be (a) that market distortions hurt social welfare (including by prolonging inflation and slow growth), and (b) that there are alternative intervention policies for the policymakers to use to achieve their economic distributional income and other social objectives without distorting important market operations. In general, the advice to the authorities would be that, to implement policies that address inflation and growth, they (the national policymakers) should intervene in markets only to ensure that the markets are competitive and open and that the market operators meet certain technical governance and operating standards. The point, therefore, is that it is highly probable that authorities of countries that interfere with, and distort, the operations of unified foreign exchange markets or, indeed, private well-functioning forex markets in general, do not know or trust alternative ways to achieve their social and distributional objectives. This possibility is supported by the fact that it is poor developing countries that are quick to lean toward interfering in the operations of forex markets, especially via the introduction of multiple forex markets and multiple exchange rates, as they try to support sectors that they think are essential to their economic growth and poverty reduction plans. As to alternative approaches, one of them could be having the government and the central bank allowing a unified exchange market to operate and the authorities concurrently design tax-cum-subsidy policies, unrelated to forex operations, in order to address their social objectives. In addition, it would be essential that the authorities are also implementing sound coherent macroeconomic policies with clear inflation and economic growth objectives. If exchange rate determination is left mainly to the market, then the ‘management’ of a high fraction of the forex ‘reserves’ of the system as a whole will be left mainly to the private sector. The central bank should, of

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course, hold foreign exchange reserves for multiple reasons, especially as part of ‘high-powered’ or ‘base money’, as ‘backing’ for its base money denominated in domestic currency, and as a valuable resource for ‘periodic market intervention’ to achieve clear welfare-enhancing objectives, including ‘exchange rate stability’, under certain circumstances. In sum, then, we would suggest three fundamental guiding principles for policymaking to achieve a socially efficient forex system, in the context of central bank independence, namely: (1) set central bank policy targets and instruments in conformity with a transparent and coherent macroeconomic policy framework; (2) establish and rigorously implement an oversight system focusing on ensuring sound operations and governance in the private forex market; and (3) have central bank selective interventions in the forex market guided by clear and transparent principles focusing on safeguarding and/or enhancing the social efficiency of the forex market operations and being in line with the central bank’s own monetary target(s) and instruments.

Governance Issues for a Socially Efficient Forex System: Transparent Macroeconomic Policy Framework It makes sense for exchange rate policymaking to be guided by some underlying and transparent macroeconomic policy framework. Consider the following basic representative model for the ‘typical’ African macroeconomy, which can be easily made transparent. This model would be especially relevant if, as this author recommends, the central bank of the African country is focusing on inflation as its primary target, while the central government (the fiscal authority) is concerned with economic growth as its primary focus. In this framework, the exchange rate is to be normally left to be freely variable, as long as the foreign exchange market meets certain standards, namely: (1) competitive (absence of domination of a few firms and/or organizations); and (2) financial institutions operating in the market are subject to regular supervision by the national supervisory authorities, to ensure conformity with international standards, especially those consistent with standards set under the aegis of the Bank of International Settlements (see, e.g., BIS 2011). The core elements of the model, which is relevant for our discussion here, and with well-known macroeconomic equations, are as follows:

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Y = C + I + G + X − M (3.1) X − M = f  E • P ∗ / P, Y ∗ , G − T , NKI ρ ∗ / ρ  (3.2) ∆NFA = X − M + NKI (3.3)

(

)

(

H = NFACB + NDACB = H ( NFACB , γ , GCB )

)

(3.4)



MO = m ( Cu / D, R / D ) • H = P • L ( r , y )



(3.5)

In a more comprehensive macroeconomic model, there will, of course, also be separate equations for C, I, and G. In Eq. (3.1), Y (gross domestic product) is the sum of consumption (C), investment (I), government expenditure (G), and exports (X) minus imports (M). In Eq. (3.2), exports minus imports (the trade surplus or deficit) is a function of (i) the real exchange rate (E • P ∗)/P, that is, the home currency price of the foreign basket relative to that of the home basket, which depends on E (the nominal exchange rate of the domestic currency per unit of foreign currency), P ∗ (the foreign price level), and P (the domestic price level); (ii) the aggregate income (Y ∗) of relevant foreign countries (trading partners), (iii) the home country’s government expenditure (G) minus taxes (T ); net capital inflow (NKI), that is, inflow minus outflow, which depends, especially, on the real rates of return on investments abroad (ρ∗) relative to those in the domestic African country of interest (ρ). In Eq. (3.3), NFA is the net foreign asset of the African country concerned (typically simply what is held in the official monetary system); ΔNFA is the change in NFA (of the African country of interest) during the relevant period of time. Equation (3.4) indicates that high-powered (base) money (H) is made up of net foreign assets (NFA) and net domestic assets (NDA) of the central bank. In addition, the function H is shown to be determined by factors including GCB (government borrowing from the central bank) and γ the central bank discount/lending rate for loans to banks. Equation (3.5) indicates that the money market is in equilibrium when money supply (MO or m • H) is equal to money demand (P • L). In that equation, m is the money multiplier (which is a function of the currency-­deposit ratio, Cu/D, and the reserve-deposit ratio, R/D); H is ‘base’ or ‘high-powered’ money; L is real money demand in the economy with its determinants being the real interest rate (r) and real output or income (y).

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The central bank policymaking approach could entail varying γ in order to influence H and thus MO, which then influences P (the central bank’s target). In the end, of course, if the central bank uses γ as its primary instrument to influence the price level (its so-called monetary policy rate), then, since the variables in the system are determined simultaneously, the central bank generally needs a complete model of the economy, along the lines of Eqs. (3.1)–(3.6), for it to be able to target a specific price level by setting γ. Among factors that will challenge the central bank in its endeavor to influence P will be GCB, namely, government borrowing from the central bank (including overdrafts), which sometimes happens because the government is running budget deficits it cannot finance cheaply by going to the market directly, or simply because the authorities believe that the central bank should provide some so-called development finance, which is supposedly good for the country’s economic growth. Since governments in most of the African countries don’t like depreciation of their currencies,1 an independent central bank’s retort typically is, and should be, that inflationary financing of government deficit results in depreciation of the currency, and any attempt to use exchange rate controls to stop that simply results in social welfare losses, via bribery, corruption, unnecessary administrative costs, and serious relative price distortions in the economy. Central bank’s lending to financial institutions, typically commercial banks, has to have constraints to prevent it from being an important source of inflation (and, ultimately, depreciation of the home currency). The central banks, in the African setting, tend to focus on two factors of self-­ constraint, namely, the level of γ constraining demand and the NFACB/H ratio which constrains supply. In principle, the latter of the two constraints is also useful in controlling government borrowing from the central bank. It is easy to see, from the above model, why countries can vary greatly in what they want to primarily ‘target’ in their policymaking under certain circumstances. Of course, among variables that can be logically and reasonably targeted, some are more ‘all encompassing’ in their macroeconomic importance and power than others. Still, poverty and income inequality typically complicate matters in the African setting, especially when adjusting in reaction to sudden macroeconomic shocks, for example, a significant and sudden drop in exports and/ or rise in imports, or when government wants desperately to raise expenditure beyond a certain point for socio-political or even economic

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­ evelopment reasons. In such cases, African countries often find it difficult d to allow an increase in the exchange rate (depreciation of the home currency) because of adverse effects on the prices of commodities and services benefitting the lowest-income groups in the population.

Oversight Ensuring Sound Operations and Governance of Forex Markets When it comes to governance of the forex markets, in general, African countries, with their experience, are developing and refining monitoring rules, organizational structures, and enforcement mechanisms to ensure that officially recognized forex operators, including banks and nonbank persons, follow rules established, and/or accepted, by the legal system and the appropriate regulatory authorities (including the central bank). The focus is especially on three categories: 1. legal and procedural rules of operations established by law and/or official regulatory authorities are being followed; 2. capacity building of operators and operational facilities of the organizations involved are continuous processes, ensuring adequate qualifications and training of personnel as well as sound capacity-­ building programs of the organizations and thereby staying up-to-­ date as regards technical knowledge, by staff members, as well as operational technical facilities in the organizations concerned; and 3. appropriate official reporting requirements are being met by the organizations concerned. In spite of such official objectives, there is constant fear that corruption is still a major challenge for regulation and oversight in the financial sectors of a number of African countries. The core of this problem takes many forms, categorized generally as money laundering and illegal or black-­ market operations, typically to avoid taxation, favor friends, and benefit from bribery, since forex trading and transfers, even by regular financial institutions, are not always organized in open competitive institutional and organizational settings in the bulk of the African countries, leaving large rooms for favoritism and judgment by the sellers. There is little doubt that, in many of the African countries, capacity building to address corruption, in this broad area, must begin with the regulatory and

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s­upervisory agencies and the senior personnel in the financial organizations (banks and forex dealers).

Selective Intervention in Forex Market In principle, when central banks intervene in the forex market in the typical African country, they do so because of ‘market failure’ of some kind, from their perspective, or because the market is ‘short’ of foreign exchange, while the central bank has a substantial stock of forex obtained from foreign aid to official bodies in the country and international borrowing by the government and state-owned enterprises. In many African countries, central bank interventions take the simple form of opening the window of the central bank and announcing buying and selling exchange rates of a few major currencies. In a sense, one could call these passive interventions or open windows. Indeed, this sort of ‘intervention’ is a regular occurrence in many African countries; most of the time, the central bank is not necessarily trying to implement some well-conceived exchange rate policy but simply ‘helping the market’ with foreign exchange supplies the ‘system’ can valuably use for the economic development of the country. Still, the intervention (passive as it may seem) typically has a major impact on the determination of the general market exchange rate of the domestic currency.2 Even more generally, the major international currencies are currently playing the role of gold in the past. So, African countries ‘back’ their own currencies with such major currencies (foreign reserves). A dilemma for the central bank is that to maintain a truly open forex market (buying and selling forex), its rates must reflect fundamentals of the national forex market, because the central bank’s closed market is really like a wholesale or middle-man market. This reality is one reason why central banks do not strictly buy and sell only in free open markets to their buyers (the banks, mainly). A central bank would often decide on quantities (i.e., quantitative rationing) in dealing with its buyers (primarily the commercial banks), since it is likely to be selling at a lower rate than in the interbank and the nonbank customary forex markets. An important question is why the ‘typical’ African central bank does not sell and buy its forex via an open auction, say on a weekly basis. Rather, when they want to deal with the private banking forex market, most of the countries’ central banks seem to prefer deciding the buying and selling rates in dealing with the banks rather than deciding the quantities for

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­ uying and selling and allowing the exchange rates to be decided via open b auctions or direct offers from the banks. The underlying reason seems to be that the central banks are trying to lead in deciding the movements in the exchange rate levels and spread. The question becomes whether that approach is optimal in an open market environment. Maybe it makes sense as moral suasion. In other words, the central bank’s level and spread will tend to affect the commercial banks’ level and spread at the same time, even if the result is quantitative rationing at the commercial banks. Unfortunately, the result could be that the central bank’s strategy keeps the foreign currency price (exchange rate level) below a truly open-market exchange rate equilibrium. But then the allocation of forex at the commercial banking level becomes open to bribery and corruption. Of course, one could argue that this is simply how central banks behave, as one can see when central bank discount rates are set. The bottom line is that in many (perhaps most) of the African countries, the foreign exchange market operates in such a way that the ‘recognized official’ market exchange rate, whatever it is said to be, is not a market-clearing price, and the allocations of forex among users are not determined mainly by ability to pay open market equilibrium forex rate(s). As far as the private forex markets are concerned, a rational solution is to ensure open, transparent, and competitive markets. For reasons of administrative and management governance factors, exchange rates may differ among banks and forex operators. In other words, there are ‘service’ components that will make for small differences in forex rates among forex dealers, even in open, fair, competitive markets. Policymakers should focus their intervention in the forex market mainly at trying to get the private forex market to work in this ideal way. Indeed, a major criterion for access of a commercial bank to the central bank forex window should be that the commercial bank’s own forex window operates under rules, processes, and organization that implement fair and open competition among nonbank market demanders of forex. This is the sort of organization and operation of the forex market that can help bring about and foster social efficiency in forex markets. If forex is distributed in open competitive markets, reflecting preferences of demanders and suppliers, then one can argue that the distribution of the forex is socially efficient. In this context, if private market dealers (especially banks) are violating the open market rules (e.g., via collusion or non-price discrimination), then the supervisory authorities should intervene and enforce the open market rules.

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Exchange Rate Regime Objectives Our view is that for social efficiency, the authorities should aim for an exchange rate regime in which commercial banks and other relevant financial institutions/organizations are licensed to operate in forex market operations freely, subject to official supervision and oversight. The central bank can still intervene in the forex market by regular (including daily) buying and selling forex at rates it decides or via periodic foreign exchange market interventions. But the central bank should not dictate buying and selling rates for commercial banks and licensed forex bureau operators. The Exchange Rate Regime, Economic Growth, and Inflation Some economists have been interested in the question of whether the exchange rate regime, per se, has effects on inflation and/or economic growth; the exchange rate regime is often classified as pegged, limited flexibility, managed floating, and freely floating (see, e.g., IMF 2015, 2016, 2018). But it is difficult to find clear theoretical foundations relating to the transmission processes involved: (1) from the forex regime to inflation, and (2) from the forex regime to economic growth. Empirically, the relationships found are all over the map and difficult to identify clear conclusions. In our view, this is not surprising, because there are no clear analytical relationships between exchange rate regimes, per se, and inflation or economic growth. To achieve the goal of identifying clear analytical relationship, one would have to show how the exchange rate regime affects various variables that in turn affect inflation and economic growth. For example, in the case of economic growth, one would have to show how the exchange rate regime affects variables such as investment level, human capital, efficiency of investment, and technological change and innovation (see, e.g., Johnson 2016, pp. 7–8). In the case of inflation, one would have to show how the exchange rate regime affects variables that in turn affect money demand and money supply. In short, for the exchange rate regime to influence growth and inflation, an important question to be answered would be: what is/are the transmission process(es)? Would it, for example, be money supply, freedom of capital flows, relevant rate of return on investment?

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Forex Market Development and Governance If the exchange rate is going to be left to the private market, which practically will be synonymous with choice of a free and flexible floating exchange rate regime, then forex market development is important, which in turn, would require serious financial market development on the whole (see, also, Bordo and Flandreau 2001; Bailliu and Murray 2002–2003). Socially Efficient Forex Regime and Management The comprehensive foreign exchange (forex) regime is about ‘governance’. It is the set of roles assigned to foreign exchange earners and users, markets, the central bank, and the government in the determination of the foreign exchange rate; the allocation of foreign exchange among users; and the goods and services on which users are free to distribute their available forex. Most of this will simply be understood, in principle, and not written in laws or regulations. Forex regime choice can be viewed as a social welfare problem, with the government policymakers deciding on the governance structure that will maximize social welfare. In that regard, one could distinguish two elements of the problem to be solved. The first element of this problem is that the forex regime facilitates minimization of the social cost of attaining any given increase in forex earnings. The second element is that the regime ensures socially optimal allocation, of any given forex stock, among domestic users, and thus ensures social welfare maximization from use of that given stock. Although several discussions exist in the literature about the economic impact of different exchange rate regimes (especially with respect to inflation and economic growth), none of them satisfactorily brings out the fact that the governance characteristics/structures/operations of different countries classified ‘officially’ within a specific exchange rate regime differ tremendously in major details. This is understandable, because if governance is taken into account, instead of three or four regimes, one could end up with ten or more regimes in the real world. Governance of the Forex Market The supervisory authorities should, perhaps, do their best to define clearly the role that commercial banks, other forex dealers, nonbank firms and

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organizations, and ordinary households can play in monitoring the forex market, in pursuit of maximizing social welfare. This means that the oversight authorities would be continuously educating the public and providing regular information to that public. Such a process could be systematically institutionalized. There is also some value in having educational programs that inform the public in venues such as schools, colleges and universities, work places, television, and radio about the basics in international investments, diversification of portfolios, and foreign exchange market operations.3 In general, the supervisory authorities should find ways to ensure that financial institutions are sufficiently alert in their asset portfolio management to ensure appropriately low average risk levels as well as diversification ensuring appropriately low correlation among risky assets. It seems reasonable to have the oversight and regulatory authorities of the system interact with forex dealers and banks on a regular basis to engage in regular discussions and seminars on market issues such as risk and returns in various forex transactions and investments. Moreover, assessments of performance of banks and other forex dealers, by the central bank and regulatory authorities, should be encouraged, and regular seminars and/or forums within the financial sector, as a whole, be held to discuss international financial market issues. Ensuring Open, Competitive, and Socially Efficient Behavior in Forex Markets The governors of the financial system (central bank, relevant government departments, and oversight authorities, in particular), should, via persuasion or explicit rules, processes, and organizational requirements, motivate the private financial organizations (in particular commercial banks and other firms and organizations operating in the foreign exchange market) to analyze continuously, and thus understand in economic analytical ways, why financial market participants (individuals, firms, and other organizations) save, invest in various kinds of assets, buy insurance, and obtain credit of different kinds. As a byproduct of such motivation, the banks, foreign exchange dealers, and regulatory and supervisory authorities of the system must strive to fully understand the factors (in particular socio-­ political-­economic) that affect exchange rate movements in the foreign exchange market(s) of the country.

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A major objective of all of the governance initiatives should be to motivate private sector market participants (via rules, processes, and organizational requirements) to behave ‘rationally’ from a societal point of view (acting in the interest of the society as a whole including the private businesses themselves), partly by enabling the market participants to have adequate information to act such that their optimal behavior (from their perspectives) leads to societal optimality. Incorporating Behavioral Factors into the Light of Neo-classical Rationality So far, we have looked at the picture in the light of expected traditional rational behavior. Unfortunately, to properly ‘govern financial market(s)’ for the benefit of the country as a whole, the ‘governors’ of the system can benefit from some understanding of behavioral factors in the utility functions of (major) market participants and how the resulting behavior could affect economic growth and development of the country. The governors of ‘the system’ will, of course, be focusing on establishing rules, processes, and organizations, for the relevant market(s), with the aim of ensuring that only those ‘players’ whose decision-making and behaviors have positive welfare benefits for the economy as a whole are able to survive the competition in the relevant market(s). Optimally, the governance system should have, as its target, ‘survival of the fittest’ from a national social welfare perspective. An implication is that the ‘governors’ of the system will benefit from understanding the important factors affecting the behavior of market participants, namely, (1) major elements in the ‘utility function(s)’ of market participants; (2) important factors in the belief systems of the market participants that influence the strategies of those participants as they try to achieve their objectives; and (3) shortcomings in the attention, understanding, and focus of market participants that influence their judgments and choices in particular real-world contexts. Behavioral Economics has shown the importance, in the decision-­ making by companies, of incorrect beliefs, which are followed because of overconfidence of managers and entrepreneurs in their decision-making, as well as biases (especially in projections of their own future preferences), which are bound to affect the performance of financial markets—for example, overconfidence about self-control, about managerial ability, about own-company performance ability, and about precision of

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i­nformation (see, e.g., DellaVigna 2009). The governors of the system (in particular, the central bank and the supervisory agencies) should have policies that address directly (especially via formal education, conferences, and seminars) such overconfidence and biases, as well as granting rewards to leading profitable financial organizations and firms that demonstrate high socially efficient market behavior. Behavioral economics has also discussed what the experts call menu effects that appear to occur in choice decision-making of individuals and managers in organizations. In particular, the behaviors highlighted among those often seen in portfolio decision-making are the following: (1) excessive diversification, (2) preference for the familiar, (3) preference for the salient (e.g., the one with meaning or prominence for the investor), (4) choice avoidance (the more difficult the choice problem, the less people want to have to make the choice despite the greater availability of options), and (5) confusion in implementing choices (see, e.g., DellaVigna 2009 and Thaler 2017). It would seem to this author that, in this sort of situation, the central bank, together with other regulatory and supervisory authorities (the governors of the system), as part of their objective of ensuring open, competitive, and socially efficient behavior in forex markets, should give regular open advice to forex dealers and investors, as well as ordinary citizens, on ways to identify and use expertise whenever those decision-makers want to make investments, or even heavy ordinary exchange transactions, in forex.

Systemic Fundamentals to Help Facilitate the Emergence of a Socially Efficient Forex Market A socially efficient forex market can greatly help facilitate social welfare optimization if certain other aspects of the macroeconomic environment are also sufficiently enabling. Below we briefly note some broad elements of factors facilitating the emergence and smooth operation of a socially efficient forex market.4 Sound Macroeconomic Policy Environment A macroeconomic policy environment likely to support a socially efficient forex market would have characteristics along the following lines: . Transparent and sound inflation policy 1 2. Capital mobility

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3. Convertibility of the domestic currency or at least an absence of exchange controls 4. Sound government fiscal policy Comprehensive Financial System Development Policymaking and Implementation The basic elements for financial system development are discussed in Chap. 2 of this book. Success in such policymaking and implementation will make easy the necessary development of a sound socially efficient forex market. Sound Financial Regulation and Oversight The regulatory and oversight systems must ensure that there is clear understanding of risks, by regulators and the financial organizations operating in the country; general agreement as to the fundamentals of how the risks can be managed; and clear and sound policymaking and implementation of the role of regulation versus the market in directly addressing the risks. Monetary and Fiscal Policy Coordination Both the central government and the central bank benefit from transparency with each other. In particular, they benefit from coordination of policy toward inflation. In short, in the African context, in general, there is some logic to having the central bank and the government jointly decide on the inflation target. The central bank should, of course, do most of the technical economic analytic work on the determinants of inflation and the effects of inflation on growth and the balance of payments. Once the inflation target is agreed, the central bank would then have the operational independence in designing and implementing a framework for achieving the inflation objective. But, as hinted earlier, the government could help the policymaking if it could let the central bank know the planned or forecast budget deficit or surplus and how it (the government) intends to finance any deficit. In that context, it is hoped that coordination between the central bank and the government would, inter alia, restrain the government from behavior that obstructs the central bank in implementing its inflation

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policy. This coordination would include agreement on central bank financing of government deficit. With coordination between the two authorities, the government will have a stake in the carefully determined ‘optimal’ inflation target, which, inter alia, will be guiding monetary policy. The inflation target, jointly decided by the two bodies, could then be made transparent to the public. There is some benefit to the policymakers to announce, publicly, some targets for critical variables such as economic growth, inflation, current account balance, export diversification, and then also set up a policy implementation organizational framework as part of the process for working to ensure that the policy targets are met. This would have very positive credibility effects, with benefits including capital inflow under certain circumstances. A useful element in macroeconomic policymaking is designing a national macroeconomic governance framework that would motivate well-­ prepared coordinated analyses by the appropriate national governing bodies working together on the various major macroeconomic policy issues. In that context, it would make sense for the government and the central bank to agree on a macroeconomic model that would guide their policymaking. Within that framework, they could agree on objectives—yearly, five-year periods, and so on, as they like—and guiding principles on how to react to shocks that are likely to affect the economy. In preparation for sudden shocks, they should also have systems in place to decide urgently, as needed, the appropriate policy reactions including the implementation processes. There is a good case for making transparent the financial market intervention policy making of the central bank. This does not mean that, necessarily, the central bank needs to announce when, how, or why it is about to intervene. Indeed, as stated earlier, the central bank could continuously ‘intervene’ in the forex market simply by quoting buying and selling rates of an intervention currency or currencies (e.g., the US dollar, euro, or the pound sterling) and listing who have access to that window.

Selective Intervention in Forex Market Operations and the Fear of Floating Selective interventions by the central bank are, in principle, supposed to be guided by ‘analytical principles’ focusing on addressing market transactions. The objectives are typically broad but specific in content, such as ‘preventing sharp increases of the forex rate’, ‘reducing fluctuations in the

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exchange rate’, ‘alleviating market distress’, or ‘augmenting central bank forex reserves’ for monetary policy reasons. Despite this objective case for central bank intervention, some researchers hypothesize that a significant fraction of such forex interventions reflect a ‘fear of floating’. This fear, in turn, emanates from deep-seated distrust of markets in certain emerging market countries for at least three reasons (see, e.g., Calvo and Reinhart 2002; Bailliu and Murray 2002–2003). One is that markets can tend to move in ‘perverse and unpredictable ways’, which we presume means that the markets unnecessarily complicate market decision-making for a significant fraction of those who have deals in forex. A second aspect of the distrust is that currency depreciations tend to be associated with economic contractions rather than expansions; hence the depreciations merely exacerbate the pressure being experienced by decision-­makers, partly because a significant percent of government and private debt in the countries affected tend to be denominated in foreign currency, raising debt servicing costs when the domestic currency depreciates. Local businesses and ordinary citizens with incomes mainly in their domestic currencies but with significant fractions of their expenditures denominated in foreign currencies also feel like they have been levied a significant ‘expenditure’ and/or ‘wealth’ tax. Third, some analysts believe that there is general fear of exchange rate floating in many of the populations of ‘emerging’ countries. In fact, a popular argument is that the monetary policy independence that floating exchange rates confer on countries can simply lead to chronic inflation in some of them. Thus, many in the populations of some of the developing countries, especially African countries, see free exchange rate floating as a major force responsible for inflation and wide economic fluctuations in their countries. In our view, sound monetary policy of an independent central bank and sound economic development and fiscal policies of the central government should make a free-floating exchange rate system far more beneficial to ­economic development than a system of fixed exchange rate and its periodic forex exchange controls that tend to occur in many poor countries. Furthermore, given that adverse terms of trade shocks are a real problem in many of the African countries, permitting a high degree of capital mobility in the context of an open-market economic system could significantly benefit the ‘typical’ African economy (and hence its economic development). Moreover, almost all the African countries would benefit

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from having an economic policy environment that is favorable to well-­ designed policies that promote economic diversification (see Johnson 2016). The relevant authorities—government and central bank—should also do their best to be transparent and credible to the public in explaining the nature and rationale for their policies.

Concluding Remarks In our view, a ‘market-determined’ exchange rate, which would effectively be ‘free floating’ should be the ultimate regime choice of the ‘typical’ African country. It is, therefore, important that such a market be ‘well-­ functioning’. This author is in favor of free capital mobility, an independent monetary policy managed by the central bank, and a freely flexible exchange rate.5 It is, in general, our view that with appropriate oversight of financial institutions in the African country concerned, combined with sound financial sector development and supervision policies, as well as sound monetary and fiscal policies of the central bank and the government, respectively, in addition to well-designed economic diversification policies of the country to stimulate economic growth, citizens of the African country should have no reason for ‘fear of floating’.

Notes 1. Still there are occasions when, even in the context of a fixed exchange rate system, a currency depreciation does make sense and/or is unavoidable (see, e.g., Johnson 1987a, b). 2. For direct intervention in markets, by the central bank, to buy and sell forex against their own currencies, in the manner of traditional ‘official intervention’ in developed countries, see, e.g., Sarno and Taylor (2001) as well as Fratzscher et al. (2019). 3. For example, in the context of the basic Capital Asset Pricing Model, ways can be found to explain, in simple terms, to the masses about the expected return from forex investment, by a forex dealer, in some asset, beginning with something in the usual form:



Es = rf + β ( Em − rf )



(3.6)

where Es and Em are the expected return of the asset (or investment) and of the market portfolio (or simply the market), respectively, and β is the sensitivity of the asset’s return to the return on the market portfolio

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(a measure of the asset’s sensitivity to market risk); r f is the return on the risk-free security. In general, the central bank and private financial institutions can also run periodic seminars on radio and television, for interested citizens and nonbank customers, explaining to them how forex markets work, and how they can engage so-called experts to advise them in the management of their forex portfolios. 4. In this context, see, also, Chang and Velasco (2000) and Bailliu and Murray (2002–2003). 5. A famous trilemma in international economics indicates that with a policy of free (open) international capital flows and independent monetary policy, a country has to give up fixed exchange rate. Our position, here, is that fear of floating should not be a problem, if the macroeconomic policymaking of the country is sound on the whole.

References Bailliu, Jeannine, and John Murray, 2002–2003, “Exchange Rate Regimes in Emerging Markets,” Bank of Canada Review, Winter, pp. 17–27. Bank for International Settlements (BIS), 2011, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems,” Basel, Switzerland. Bordo, M., and M. Flandreau, 2001, “Core, Periphery, Exchange Rate Regimes and Globalization,” National Bureau of Economic Research, Working Paper. Calvo, Guillermo A., and Carmen M.  Reinhart, 2002, “Fear of Floating,” Quarterly Journal of Economics, Vol. 117 (May), pp. 379–408. Chang, Roberto, and Andrés Velasco, 2000, “Exchange-Rate Policy for Developing Countries,” American Economic Review, Vol. 90, no. 2 (May), pp. 71–75. DellaVigna, Stephano, 2009, “Psychology and Economics: Evidence from the Field,” Journal of Economics Literature, Vol. 47 (June), pp. 315–372. Fratzscher, Marcel, Oliver Gloede, Lukas Menkhoff, Lucio Sarno, and Tobias Stöhr, 2019, “When is Foreign Exchange Intervention Effective? Evidence from 33 Countries,” American Economic Journal, Macroeconomics, Vol. 11, no. 1 (January), pp. 132–156. Ghosh, Atish R., Anne-Marie Gulde, and Holge C. Wolf, 2002, Exchange Rate Regimes: Choices and Consequences (Cambridge, MA: The MIT Press). International Monetary Fund, 2015, “Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries,” IMF Staff Report, October. ———, 2016, “Exchange Rate Regimes in Sub-Saharan Africa: Experiences and Lessons,” World Economic and Financial Surveys, Regional Economic Outlook, Sub-Saharan Africa Multispeed Growth, October 2016, pp. 31–60. ———, 2018, Article IV Consultation, Staff Report, Nigeria, March. Johnson, Omotunde E.  G., 1987a, “Currency Depreciation and Export Expansion,” Finance & Development, Vol. 24 (March), pp. 23–26.

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———, 1987b, “Currency Depreciation and Imports,” Finance & Development, Vol. 24 (June), pp. 18–21. ———, 2016, Economic Diversification and Growth in Africa: Critical Policy Making Issues (Palgrave Macmillan). Sarno, Lucio, and Mark P.  Taylor, 2001, “Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?,” Journal of Economic Literature, Vol. 39 (September), pp. 839–868. Stotsky, Janet G., Manuk Ghazanchyan, Olumuyiwa Adedeji, and Nils Maehle, 2012, “The Relationship between the Foreign Exchange Regime and Macroeconomic Performance in Eastern Africa,” IMF Working Paper WP/12/148, June 2012. Thaler, Richard H., 2017, “Behavioral Economics,” Journal of Political Economy, Vol. 125 (December), pp. 1799–1805.

CHAPTER 4

Attaining Sound International Financial Center Status

Abstract  The geographical area in which an international financial center is located must be attractive as a place where people want to live, work, and visit. A policy strategy for developing a financial center will involve conceptualizing the center as a cluster; finding a niche for entry at the international level, in terms of clientele, products, and appropriate service providers; enhancing competitiveness by building capacity, structuring incentives, and improving the quality of the national governance environment; and putting in place high-quality financial services supervision and regulation. The capacity of the financial center will be built by strengthening the institutions (rules governing behavior), organizations, and mechanisms in the host country to support innovation in financial services; investing in appropriate human capital; raising financial capability of citizens; and putting in place appropriate physical and technological infrastructure. Keeping taxation at low rates will also be helpful. Selective intervention policies to promote the center can include assisting with market research and information on new products and knowledge inputs; making available critical infrastructure and public services at competitive costs to users; and making a special effort to patronize the center especially via demand for its services. Keywords  Socio-political environment • Cluster • National coordination council • External economies • Capacity building • Microeconomic incentives • Socio-political governance • Promotion • © The Author(s) 2020 O. E. G. Johnson, Financial Sector Development in African Countries, https://doi.org/10.1007/978-3-030-32938-9_4

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Enclave privileges • Niche • Financial Area Corporation • Risk controls • Market discipline • Stress testing If an African country has a fairly well-developed financial system, and a socially efficient foreign exchange market, achieving the status of a sound international financial center could be well within its reach, if it chooses to build one, irrespective of the economic size of the country in terms of gross domestic product (GDP). Mauritius and South Africa, for example, have achieved significant international status, in the area of international financial center development (see Table 4.1), with potential to continue making progress. With appropriate policymaking and implementation, other African countries can achieve similar status. To become a reputable and attractive international financial center, a country needs to attain some basic world standards and practices in its financial sector development and its overall socio-political-economic development. Apart from having some world-class commercial banks, a well-functioning and significant stock market, as well as some other high-­ quality relevant types of specialized organizations (such as insurance companies and pension funds), desirable qualities of the country’s environment, to attain such a status, would include the following: • a convertible currency; • open capital markets for participation by international investors and financial firms; • workforce with appropriate skills and protected by internationally accepted labor laws; • quality of life that is attractive to high-level professionals of all types; • fair, transparent, and efficient legal and regulatory regime; • transparent and internationally competitive tax regime; • low cost (by world standards) of doing business; • high-quality, reliable, and appropriate physical infrastructure; • sound and transparent corporate governance (rules, processes, and organization); and • stable political, social, and economic environment. The country in which a center is located must be attractive to live, work, and visit. Hence, transportation, housing, hotels, physical security, medical services, facilities for leisurely activities (theaters, museums, art

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Table 4.1  Selected global financial centers, 2018—top 60 1. New York 2. London 3. Hong Kong 4. Singapore 5. Shanghai 6. Tokyo 7. Sydney 8. Beijing 9. Zurich 10. Frankfurt 11. Toronto 12. Shenzhen 13. Boston 14. San Francisco 15. Dubai 16. Los Angeles 17. Chicago 18. Vancouver 19. Guangzhou 20. Melbourne 21. Luxembourg 22. Osaka 23. Paris 24. Montreal 25. Tel Aviv 26. Abu Dubai 27. Geneva 28. Casablanca 29. Cayman Islands 30. Bermuda

31. Qingdiao 32. Taipei 33. Seoul 34. Doha 35. Amsterdam 36. Washington, DC 37. Dublin 38. Cape Town 39. Munich 40. Kuala Lumpur 41. Hamburg 42. Calgary 43. Edinburgh 44. Busan 45. Wellington 46. Monaco 47. Jersey 48. Bangkok 49. Mauritius 50. Glasgow 51. Vienna 52. Tallinn 53. Madrid 54. Brussels 55. Sao Paulo 56. Milan 57. Johannesburg 58. Stockholm 59. Bahrain 60. Guernsey

Produced by the Z/Yen Group and published in the Global Financial Centres Index, September 2018. The index is ‘based on external benchmarking data and current perceptions of competitiveness’. The rankings do change, typically marginally, from one year to the next

galleries, other cultural attractions), and educational facilities must be of high quality. Much has been written about countries taking carefully thought-out steps to keep improving the competitiveness of their financial centers.1 In Europe, for example, both Germany and France took well-organized steps beginning in the 1990s, which, for a while at least, raised serious concerns for promoters of the City of London.2 Among the United Kingdom’s reactions was the reinvention of the organization, British Invisibles, to

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become, on February 1, 2001, the International Financial Services, London (IFSL) and to focus more coherently and resolutely on promoting the UK-based financial services industry throughout the world.3 Thus, there is a broad agreement on the major characteristics of a world-class financial center, and many places with reputation of having achieved international financial center status, although of varying degrees, are continuously engaged in planning and promotion to gain increasing competitive advantage in the international financial center business. This means, inter alia, that competition in that business will only get stiffer over time. Clearly, there are implications for new and aspiring entrants, especially those for which the financial center business, even for the domestic market, remains significantly underdeveloped. For new entrants, a coherent strategy, including clear benchmarks, would be useful, to facilitate objective monitoring and assessment of progress. In addition, a simple and obvious way to start is to learn something about the experience of leading centers, particularly in the same geographical region and with closeness in population size. That will help the newcomers in their attempts to define the problem and to design an appropriate strategy. For the vast majority of the countries in Africa, more financial development is needed and valuable in its own right (the subject of Chap. 2 in this book). Hence, such countries should want, in any event, to have a coherent program for developing their financial systems. The idea of any of the countries striving to build an international financial center is merely to ensure that, in the process of developing the financial system, there is, as an integral element, namely, a well-thought-out strategy for starting a robust export business in financial services. In this chapter, we outline a strategy for developing an international financial center, which builds on the stock of international experience in that area. This strategy entails the following: • conceptualizing a financial center as a cluster; • finding a niche for entry at the international level; • enhancing competitiveness by building capacity, structuring incentives, and improving the quality of the national governance environment; • putting in place high-quality financial services supervision and regulation; and

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• promoting the center by assisting it to access global value chains, implementing appropriate selective intervention policies, and granting the center some enclave privileges. The strategy would involve substantial cooperation among the government, the central bank, the financial services supervisors and regulators, and service providers in the financial sector and/or center, as relevant.

A Financial Center as a Cluster A financial center, whether international or purely domestic, is a cluster or agglomeration of markets and firms in financial and other related services. For example, a first-rate financial center typically has a fair number of the world’s top 10–20 commercial banks with a branch, or branches, in the country. Seeing the financial center itself as a cluster and understanding the benefits of clustering and the sources of the benefits should help organize thinking on strategy and the ordering of actions to develop such a center. Benefits of Clustering The most fundamental benefit of clustering is knowledge externality. Firms are embedded in a network of users, suppliers, consumers, and knowledge producers. In general, a well-functioning cluster will be characterized by increased collective efficiency. Collective efficiency accrues to clustered firms from two factors: external economies, generated from the agglomeration of firms, and joint action. At least four types of external economies have been outlined in the literature: market access, labor market pooling, intermediate input effects, and technological (or, simply, knowledge) spillovers. Market access has to do with the ability to attract buyers of the services as well as suppliers of inputs. Labor market pooling is associated with concentration of specialized skills that will tend to develop within the cluster. The pooling will occur through skills upgrading within the cluster and the attraction to the cluster of persons who already have relevant skills. Intermediate input effects are externalities associated with the emergence of specialized suppliers of inputs and other services. This will be due ­especially to specialization among existing firms in the cluster or attraction of new firms from outside. Technological (or knowledge) spillovers involve

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the diffusion of technological and other knowledge and ideas among the firms in the cluster. Collective efficiency, in other words, augments the benefit to any service supplier of locating within a well-developed and functioning cluster and thus attracts investors and potential users to the cluster. An important consequence of all this will be greater depth and liquidity in the financial markets located in the center.4 Hence, the opportunities for hedging, trading, and diversifying risks will expand as will be the access to alternative sources of funding and to greater investment opportunities. Balance sheet management will be easier. To reap the full benefits from clustering, there need to be high levels of collaboration and interaction among key agents and organizations in the cluster. In particular, effective communication and cooperation among firms will create opportunities for joint action. Such agglomeration effects will also help the clustered firms shape patterns of innovations and technical change.5 In short, when they work well, clusters help enterprises innovate, and upgrade their processes, products, and functions. Like other types of clusters, financial centers can emerge spontaneously or via central direction and planning (constructed clusters). The most famous case of the latter is probably Singapore. Dubai is a more recent example. For newcomers, in order to speed up the development process, some central coordination of the institutional and organizational activities should be useful, if carefully done. The role of the firms, markets, and individuals in the center will be mainly to (1) advise clients on various financial matters, (2) structure and arrange deals, (3) provide finance to borrowers and equity issuers, and (4) manage funds and investments of individuals, firms, and so-called institutional clients. In the process, they would perform the five basic functions that have been highlighted in the finance and growth literature.6 Namely, they will: (1) facilitate the trading, hedging, diversifying, and pooling of risk; (2) allocate financial resources among competing users; (3) monitor managers and exert corporate control; (4) mobilize savings in all the geographical areas they serve; and (5) facilitate the exchange of goods and services in their niche countries. A dense financial center (cluster) will contain a substantial number of fair-sized financial services firms; major international accounting firms; legal, trustee, and custody services and telecommunications; and ­computer engineering firms (including consultancies). The financial services firms will, as a sector, be highly diversified with firms engaged in activities

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covering the whole spectrum in major areas like banking, securities, foreign exchange trading, insurance, derivatives, fund management, and professional services. Not being strict about ‘firewalls’ (e.g., between bank and securities business) will facilitate open competition among financial services firms, joint action, and exploitation of external economies. Organizational Issues To reap the full benefits of clustering, there need to be high levels of collaboration and interaction among key agents and organizations in the cluster. Left to evolve spontaneously, such cooperation could be slow in emerging, especially in the early stages of development of a center. Hence, there will be benefit to all, under such circumstances, from official intervention to foster the process of cooperation. The authorities will need, though, to be cautious in their approach to enhancing cooperation among firms in the center. In particular, the authorities must ascertain that, in fact, there will be benefit of intervention. Once they feel a need to intervene, they should avoid imposing their agendas or preferred processes; rather they should allow these to emerge via discussions and negotiations among the firms, even if with government participation. The authorities should simply play the role of facilitators. In that case, they must ensure that their representatives have credibility, especially by demonstrating knowledge and competence. More generally, there will be major issues associated with developing the financial center in a coherent and efficient way. Because of this, rational organization will help. A reasonable approach would be to establish some national coordination council, say an International Financial Services Development Council (IFSDC). This council would comprise representatives from the national government, local government, the central bank, the financial services supervision authority or authorities, and the major sectors of the financial services industry. The objectives of the IFSDC would be (1) to promote cooperation among all public and private persons and authorities with substantial interests in the development of the financial center; (2) to promote adoption of standards and practices in the financial center that meet international norms; and (3) to promote policies, institutions (i.e., rules governing behavior), and infrastructure, which enhance the international competitiveness of the center, including the ­fostering of beneficial innovation. Within the IFSDC, ideas should be openly discussed. It would be a forum where the different parties would

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be informed of what others are doing. Such information should motivate joint action and timely exploitation of external economies. Also, the national authorities would be able to hear suggestions and criticisms, from private parties, that could improve policy plans and actions. It would be useful to have working groups within the IFSDC structure to develop initiatives and ideas on different aspects of the financial center development. Final decisions, when necessary, can then be taken by the whole group; alternatively, there could be an IFSDC board, which arrives at such final decisions. The IFSDC would be concerned with all aspects of the financial center development. But its focus would be on broad policy matters and on hearing all sides of an issue. As regards its legal status, the IFSDC would be an advisory group to the authorities and to the industry as a whole. But it should have enough stature to make its decisions respected. This would be aided by it being able to arrive at recommendations by consensus, after hearing all sides.

Finding a Niche The financial services industry can be subdivided into sectors that supply a variety of products, where a product is a specific bundle of services. The products in this case are highly heterogeneous. Still, it is a highly competitive industry; in fact, groups of products compete with each other. A financial center that is a newcomer in the international financial center business may, inevitably, have to start as a niche center, for some time. Indeed, geography, rather than range of services, will most likely be the more dominating factor determining the niche. Of course, for some time there may need to be a niche also in terms of products. But a newcomer financial center is unlikely to be a global niche for any service area for some time to come. Still, the speed with which the Dubai International Financial Center established itself shows what is possible, particularly with substantial investment in financial and other infrastructure, generous tax incentives, and legal framework flexibility. Clientele As to geography, it makes sense for an African country intending to build an international financial center to begin with its regional economic ­community7 and then slowly expand to the rest of the African continent and beyond. Within such a niche area, the clientele could still be diverse.

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In particular, it would include governments, public enterprises, local financial institutions, foreign companies that have operations in Africa, and Africans in the Diaspora that are particularly residing in Europe and North America. As African enterprises in the financial center grow in size and become more efficient and reliable, they should be able to raise and manage outside finance from a global market. Products and Services Among the factors to help ensure a solid and rapid progress in a country’s financial center services would be: an active and growing stock market; sound commercial banks and insurance companies; well-managed pension funds; freedom of capital movements in and out of the country; and an active, open, and private foreign exchange market. To bolster a financial center’s cluster orientation, all the major categories of services could be targeted. These would include: (1) foreign exchange services—for instance, obtaining funds from financial firms abroad and lending them domestically or regionally, especially to banks, and vice versa; (2) loan syndication; (3) stock and bond issues in local and foreign-denominated currencies; (4) fund management of various sorts; (5) money management; (6) mortgage; (7) insurance; and (8) monitoring and rating services covering firms, governments, and various kinds of securities and instruments. Indeed, more and more African countries are establishing pension funds and there are indications that many of these are not being managed well. Foreign exchange reserves of countries can also be better invested. Competitive commissions and fees, as well as internal management expertise, can help attract sound fund-management services from high-quality agents and organizations in well-run African international financial centers. Providers From an organizational point of view, the providers of financial services, who must all be of high quality in order to foster the idea of the center being a true cluster, are obvious. Clearly, banks, insurance companies, and other companies with large fund-management investments will be at the core. The stock marketError! Bookmark not defined. should be well functioning with international listings. Banks should cover investment, corporate, and retail banking. These highly diversified organizations can

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be supplemented by specialized organizations, such as mutual funds, investment trusts, leasing companies, factoring companies, credit rating agencies, professional service consultancies, and research and risk analysis service firms. Futures and options exchanges as well as commodity exchanges could follow later, if economically efficient to do so. The idea is to encourage the specialized firms and organizations to emerge and operate well, by international standards. The authorities are well advised to be proactive in trying to ensure that the financial center be an innovative cluster. That is, the authorities, perhaps working under the aegis of the IFSDC, should promote high rates of learning and knowledge accumulation within the service firms of the center. There is a good case for taking a formal approach to ‘markets’. Namely, markets like stocks, bonds, government securities, money, foreign exchange, futures, and options should be clearly identified. The identification is useful for reasons of regulation, supervision, or oversight. Hence, there will be regulatory rules and requirements, for instance, relating to risk management, settlement of transactions, and corporate governance. But there may also be rules for participation and transacting that are designed for reasons of market efficiency and smooth cooperation among the participants. Indeed, such rules could be codified as bylaws when a ‘market’ has an exchange or centralized trading place. A decision that will need to be made at the beginning will thus be whether it is a good idea for some markets to have centralized trading or exchanges. Of course, even in such an eventuality the trading does not need to take place in a centralized physical locality. Transacting could take place via modern communication devices. But, in general, when the trading is centralized, ‘membership’ to the exchange or ‘market’ would be a requirement for participation. To be in good standing, a member would need to be in compliance with both the regulatory requirements and the rules of good behavior in transacting with other members.

Enhancing Competitiveness: Capacity Building As in so many activities, reputation is important in the financial services business. With good reputation comes credibility of promises, expectations that the authorities are serious and committed to building a world-­ class financial center, and respect for the competence and integrity of the firms and service providers in the center. Now capacity to do the job well enhances reputation. A strategy must therefore be put in place to build

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capacity of the people and organizations in the center to perform their tasks well. In addition, mechanisms must be found to influence perceptions of the center by outsiders, in order for the center’s service providers to be given the opportunity to demonstrate that they can indeed perform the tasks efficiently. Thus, capacity building must be supplemented by mechanisms that influence outsiders’ perceptions of the center’s ability to perform tasks for which it (the center) has not yet established a solid reputation. Capacity building and positive outsiders’ perceptions will both be facilitated by the quality of the relevant innovation system, the human capital of the center, the financial capability of residents in the niche countries, the supporting infrastructure, and the steps taken and being taken to improve effectiveness and efficiency of cooperation in the cluster. Innovation System Continuous innovation is unavoidable for the success of any financial center that is trying to keep up with the competition, the changing environment of the world economy, and the regulatory refinements of authorities of countries worldwide. In trying to maintain a highly competitive international financial center, the relevant African country authorities will be advised to continuously examine closely their financial sector innovation system and their country’s financial regulatory framework to ensure that they motivate their financial center firms and operators to stay abreast with the leading financial centers of the world. Indeed, firms in the financial center will often need to use and supply products and procedures, in dealing with clients that are not used to them. Innovation will involve copying and catching up with products and practices of others; research to facilitate appropriate adaption of existing products to the specific clients and/or environment of the center; investment in new equipment; organizational reforms; learning new skills, including technical and analytical knowledge (mathematics and statistics, finance, economics, software programs, etc.); and adopting new approaches in marketing and in cooperating with other financial centers. An important policy objective of the national innovation system is, of course, to enable and motivate domestic firms to develop sufficient technological, organizational, and scientific sophistication and adaptability to compete effectively in this and other areas in the global environment.

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Strengthening the national innovation system and making it supportive of the financial services sector would involve looking at the quality of secondary schools; programs at universities, research centers, and institutes; technical and vocational training in the country; and training and research programs within firms of the center (see, e.g., Johnson 2016). Apart from training and research facilities, there are other important factors which will influence the innovation system and which the authorities must influence. Among these, habits and practices of major actors in the financial system are important. Firms must be motivated to inculcate habits and practices which encourage innovation. In that regard, the incentive structures within organizations matter. The competitive environment is also very important. National policy fostering open markets and safeguarding their integrity will be good for innovation. Incentives for export-orientation in production will also encourage innovation and survival of only strong firms which tend to be more innovative. Labor-management relations matter, inter alia, because they can influence attitudes and commitments toward technical change and innovation. Moreover, availability of finance to support innovation (including acquisition of equipment and training) is extremely important; government policies can influence this, as can cooperative arrangements among firms and organizations in the center. Human Capital The quality of the human capital at the financial center will be crucial to its success. The technical capability, innovative ability, and integrity of the human beings operating in the center and overseeing its markets and organizations will all be very important. Indeed, many of the policies being implemented to boost the development of the center should be designed with an eye to attracting high-quality personnel. The indispensability of high-quality people to achieving a high degree of competitiveness has forced all centers seeking to compete at the international stage to be open in their recruitment policies, acquiring people from wherever they can be found. Any African country wanting to build a world-class financial center will have no alternative but to adopt such an approach. Given sound government policy, including support for sound education and training of the country’s citizens, within a not-too-long period of time, the African country concerned will have a significant (not necessarily majority) share of its own citizens in senior positions of the leading

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financial firms of the country. But the African country should understand that international financial firms and conglomerates thrive on their diversity and their ability to rotate their employees worldwide. The authorities in the African country concerned should not only welcome such international firms to their center but also refrain from restricting their freedom and flexibility in their personnel management. Similarly, fund managers, advisors, and consultants of foreign origin should be encouraged to open offices in the African financial center, if they so wish. An experienced and high-quality labor pool should enrich the center with appropriate efficiency gains. Two areas with thorny issues that all financial centers have had to address are labor policies and personal income taxation. In the case of labor polices, the main issue is the degree of freedom and flexibility that the top management will have with respect to freedom in hiring and firing, overtime pay, minimum wage, leave, treatment of unions, and hiring of foreigners, at all levels of the firm. A cautious approach would be to take a survey of what countries with leading financial centers are doing at the moment and adopt policies that are sufficiently flexible in light of competitiveness considerations as well as normal practices in the host country. The same can be said for personal income taxation. First and foremost, the African country concerned should perhaps negotiate double taxation treaties with at least those countries where the risk of double taxation exists. As to the level of taxation when relevant, the advice again would be to do a survey of the leading financial centers and get a good idea of their personal taxation, both of nationals and of foreign nationals who are, or plan, to be residents in the home country. Then, if needed, an attempt should be made to modify domestic taxation laws (especially those that affect the international financial firms) to become competitive. Infrastructure and Public Services The physical and technological infrastructure in place will be important elements of the capacity available to perform the financial services tasks. This infrastructure will comprise: (1) transport and communications networks; (2) basic utilities such as electricity, water, sanitation, and postal system; (3) accommodation (housing and office space); and (4) financial system related infrastructure (such as trading facilities, clearing and ­settlement systems for money and securities, various electronic linkages among participants).

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Broadly speaking, the sort of infrastructure needed to enable a financial center to function effectively is well known. When it comes to the details, it is also known that user requirements (effective demand) must drive the process. The challenge is achieving economic efficiency in the supply of infrastructure. For this, organization is crucial. This is so because someone or some decision-making authority needs to answer questions like: Who builds what? How are facilities and services financed? How does one sequence the accumulation, reform, or remodeling processes as needed? What is the time frame for long-term decision-making and what is the discount rate to be applied? Some of the infrastructure decisions and the investments will, of course, be left to the financial services markets and firms themselves. So, let us focus here on public sector organization. To begin with, the central government and the local government will have clear functions specified in law regarding the provision of infrastructure and other public services. A suggestion here would be that the effectiveness and efficiency in those areas could be enhanced if a dedicated authority is created to deal with some of the requirements of the financial center geographical area. In other words, a Financial Area Corporation (FAC) could be formed and given land and other capital to build and manage certain office space and perform other functions devolved to it under agreement with the national and local authorities. The way the FAC finances itself—following the initial grants—will depend on its duties. If all it does is manage buildings then it will simply raise money through lease or rental income. But if it has municipal functions like garbage collection, policing, fire service, or maintenance of parks in the financial area, then it would need to tax the businesses in the financial area. These sorts of questions would need to be addressed by the political authorities of the country. So, also, would be the issues of ‘who makes the capital grants to the FAC’ and ‘to whom is the FAC accountable’.

Enhancing Competitiveness: Microeconomic Incentives to Enterprises The economic returns to the people and firms that operate in the financial center will be affected by the policy environment. Obviously, if the marginal returns to businesses in the center are low, people and firms that can earn higher returns elsewhere will leave, until an appropriate stock is left,

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such that the marginal returns to those who stay equals the returns they would earn elsewhere. Therefore, the incentives to attract and retain high-­ quality people and firms in the financial center are extremely important. We have already addressed some incentive issues when discussing human capital above. We also mentioned the overwhelming consensus that the quality of life matters. Hence, making the geographical area in and around the financial center attractive to live in will be a positive incentive to enterprises. Later, we shall briefly discuss governance issues, which also can affect the structure and hence the behavior of enterprises vis-à-vis the financial center. In this section, we want to briefly discuss issues of openness, taxation, administrative obstacles, and the legal environment. Openness In order to be truly competitive in the international financial environment, the financial center will need strong firms—by definition, firms that can survive in open competitive markets. In order to attract such firms and keep them, an overarching requirement is the maintenance of an economic environment (markets, institutions, immigration, information flows, ideology, and access to authorities) that is open. An open environment will exhibit several characteristics. First, there will be fair and open access rights to all to locate in and/or do business with the firms and organizations in the ‘center’, irrespective of national ownership of a firm. Hence, firms with 100 percent foreign ownership will be welcomed into the center. Especially in the early years of the international financial center, such firms have the potential, when properly screened using objective standards, of bringing badly needed expertise and business connections to the center. Second, ‘firewalls’ limiting the types of business to be engaged in by the same firm/organization will not be too restrictive, that is, not out of line with the leading financial centers of the world.8 Third, innovation will be encouraged, that is, without regulatory and other obstacles that are more stringent than those found in the leading financial centers. Fourth, there will exist institutionalized procedures through which policymakers and regulatory and supervisory authorities consult and elicit the opinions of financial services providers before implementing new or revised rules, taxes, and other costly obligations on the financial center markets, firms, and people. The authorities must also demonstrate that they seriously consider the views and analyses of the financial center organizations before finalizing their decisions. Fifth, there

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must be a high degree of freedom and flexibility allowed to firms in their day-to-day operations. Hence, they must be allowed capital mobility, currency convertibility in an open exchange market, and implementation of human resource management policies that enable them to accumulate the human capital they find optimal. Taxation Taxation will, of course, also be of great importance in the policymaking. There is corporate taxation; taxation of wages, salaries, interest, and dividends; taxation on capital gains; and taxation of specific transactions. Then, of course, there can be all kinds of taxes in the form of fees which are not labeled as ‘taxes’. Rather they may be called registration fees, stamp duties, or transfer fees (such as when shares are transferred). Governments in their tax policies are usually concerned with revenue, fairness, income distribution, protection, and efficiency. In the context of a financial center, it is useful for the authorities to see the problem as one in which they are trying to promote exports (of financial services), enable the financial center to attract and keep talent, and attract foreign direct investment to the center. Hence, the taxation of the financial services must not do damage to the competitiveness of the center in any of these dimensions. In addition, certain elements of the bargaining power (i.e., the special nonpecuniary attractions and indirect pecuniary benefits) of operating in the center are not likely to be great, at least in the initial couple of decades. So, there will be no rents to be captured. This means that the solution to the tax problem is straightforward. The taxes mentioned above cannot, in their total burden on the firms and the highly talented employees, be higher than appropriate competitor centers. Rather, it makes more sense for the general burden of the different taxes to be as favorable as the most favorable of the top 50 financial centers in the world. Similarly, if special incentives are granted to exports of any kind, there is no reason why financial services exports should not be extended similar benefits.9 There would need to be given careful attention to certain details, though, since the firms and individuals in the financial center would most likely be providing services to domestic residents as well. Indeed, the concept of what is an export may itself be difficult to define for certain transactions. A general advice would be to look carefully at what others are doing and be as competitive as possible with respect to the types and levels of

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taxation. Double taxation treaties, for instance, should be signed where useful. Many countries have also been directly addressing certain specific taxes that are relevant in this area. One could benefit from what those countries are doing and at worst match the most favorable ones, in order to be competitive. For instance, the much-discussed UK investment manager exemption should be copied. The idea is that using a UK investment manager to carry out permitted transactions should not obligate a nonresident to UK tax, when the nonresident has no other connection with the United Kingdom. The transactions which must pass certain tests are covered in the legislation (see HM Treasury 2007).10 In its attempt to examine the tax code to remove elements that would be discouraging to the development of an international financial center, the African country concerned may use the opportunity to reform the whole tax system. A compelling reason may be that some taxes may not be easy to remove or lower for the financial system without doing so for the whole economy. A way around this is to make the center an enclave (see later), which will allow it to enjoy special tax privileges not enjoyed by firms, organizations, and individuals outside the enclave. Administrative Obstacles There should be a special effort made to reduce administrative obstacles to investment in, and entry into, the international financial center, especially to foreign firms and individuals. In brief, the barrage of licenses, approvals, permits, and other requirements should not unduly raise the costs of setting up and doing business in the financial center. A one-stop agency or subdivision could, for instance, be set up for the center within the jurisdiction of the Financial Area Corporation (FAC). This agency would handle all the administrative requirements for the initial set up. But it should also be ready to assist in special needs during operations. For example, problems with utility companies, the tax authorities, and the immigration office could be greatly alleviated by such an agency. The agency, of course, would serve all the firms and organizations in the financial center and not just those with foreign ownership. Legal Environment The law, the courts, and the police would all need to be reviewed in light of the requirements to make the center competitive. It would be advisable

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to do a formal review of the legal system in light of the experience of the top international financial centers to ensure that the legal framework is adequate. At the same time, there would be need to consider whether the regular courts are equal to the task of enforcement, mainly in light of the normal efficiency with which that system operates. The evidence on this score must be clear, since the courts have been handling cases in which the financial services sector has been involved. If the evidence indicates that the court system is not up to the task, especially in terms of speed and decisiveness, then thought should be given to creating a special court system for the financial center. This, again, would be logically easy to defend if an enclave approach is taken in dealing with the financial center. The issue of jurisdiction of the court would then need a lot of thought, but the problem is still solvable.

Enhancing Competitiveness: General Governance The overarching policy environment of the country in which a financial center is located greatly affects the rating of the financial center among peers and among regulatory authorities in other countries of the world. Hence, given the abundance of alternatives, strong firms and highly talented people may not find it good for their reputation to consider working in, or having business relations with, a center located in a country that is considered poorly governed. In addition, the governance of a country has immediate wealth effects on the owners and employees of firms and organizations that locate, or do business with firms and persons, in a financial center in that country. Of particular importance are three components of the national governance environment, namely, macroeconomic policies, socio-political governance, and the degree of compliance with relevant international standards and codes. Macroeconomic Policies Macroeconomic policies are important for obvious reasons. They will affect the expected real rate of return on earnings by the financial center’s participants; the expected real value of investments and other assets in the center, over time; and the ability to transfer assets and earnings in the center from the domestic economy to another country. Thus, a financial center benefits from low inflation, stable exchange rates, capital mobility, and convertibility of the domestic currency or at least an absence of exchange

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controls. Maintaining these elements of the economic environment of the country is important for the competitiveness of the center. But so are the means by which these objectives are met. The manner in which the central bank uses its instruments to achieve its objectives of low inflation and financial system stability will affect competitiveness of the center. Among potentially harmful instruments are reserve and liquidity requirements; these should not be used in ways that tax banks or seriously reduce the flexibility of their reserves. Central bank fees and other regulations for use of payment system facilities it controls should also be no more onerous than those in other leading centers. Capital mobility will pose challenges. A country cannot really be a big player in the international center business if it has stringent capital controls—inwards and outwards. At the same time, capital mobility complicates risk management for individual financial firms and makes macroeconomic management more challenging.11 Assuming that other governance aspects (to be discussed below) are consistently well taken care of, the basic strategy is twofold. First is to put in place a macroeconomic policy framework that ensures low inflation and exchange rate stability (not fixed exchange rate). The second is to ensure that the financial system is sound, most importantly by establishing a prudential framework appropriately designed and tailored to meet the challenge. An important quality of such a prudential system will be that: (1) there will be clear understanding of risks by those who are the bearers of the risks; (2) the responsibility for managing risks in financial transactions are clearly assigned; and (3) there are appropriate incentives to those responsible for managing risks to do so in a socially efficient way.12 No matter how sound the underlying macroeconomic policy and prudential framework, it is doubtful that the probability of a financial crisis can be reduced to zero. Hence, as part of the public policy framework, the authorities will be well advised to have measures in place to address crises when they do arise. Having a policy response fairly well thought out in advance is indeed important. Liquidity support (typically from the central bank) and fiscal support from the government are the overarching elements of such a strategy, coordinated with emergency measures by the regulatory and supervisory authorities.13 Socio-political Governance One of the problems that policymakers will have to address is that a financial center being located in Africa might face having to effectively pay a

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premium to attract, to the center, strong firms, highly talented people, and businesses, because of uncertainties related to political instability and governance. Investors will worry about corruption, government efficiency, maintenance of rule of law, and sustainability of policies. Strategies must therefore be developed to build credibility for political stability, low level of corruption, and good governance. Obviously, Mauritius and South Africa have been doing a good enough job in that context to maintain their reasonably good standing in the international financial center world.14 When assessing countries on corruption and good socio-political governance on the whole, as mentioned in Chap. 2 many analysts will resort to surveys and indices purported to measure, for instance, risk of expropriation, general governance indicators, and constraints on the executive. It would seem sensible for the authorities of an African country wishing to develop an international financial center to treat such surveys, indices, and reports with the same seriousness as they would a credit rating report. In other words, as a first leg of a response strategy the authorities should try and understand what goes into these reports and what they can do to improve their ratings. This will help them design an appropriate plan. A second leg of a strategy is, of course, to design a plan to improve general governance—with clear objectives and instruments—make it transparent, and then implement it resolutely. In designing the plan, the authorities should remember that they will need to worry about sustainability during implementation. For this reason, especially, particular attention should be paid to the deliberative process in putting the program together and to the legal and organizational framework involved.15 Thus, an African country with ambitions to have an international financial center should try to raise its governance ratings. Mauritius and South Africa (Johannesburg) are not perfect but they are listed among the top 60 financial centers in the world (Table 4.1), inter alia because their governance reputations have been sufficiently high and attractive to international financial center personnel, firms, and major financial organizations. Compliance with Appropriate International Standards and Codes In trying to develop an international financial center, it is even more important that the country clearly demonstrates that it is resolutely implementing widely accepted financial standards and codes. Otherwise, of course, the rating of the center, among peers and by regulators in other

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countries, will tend to be poor. In that case, the center will not be able to significantly participate in the exportation of financial services. In general, then, it will first and foremost be useful, for a newcomer or aspirant, to develop domestic expertise to implement the full compliance process, starting with a self-assessment of the state of compliance (to specified international standards and codes). Even with such expertise, any developing country will still find that, for credibility, it will have to undergo peer review by experts from the leading financial center countries of the world and/or from appropriate international organizations; such a procedure, in essence, would be simply to validate the country’s own self-­ assessment and implementation of compliance.

Regulation, Supervision, and Oversight of Center The regulatory environment affects the competitiveness of a financial center. High-quality regulation, supervision, and oversight should, as a minimum, prevent firms from taking excessive risks, while not so overbearing as to frustrate innovation in financial services. Hence, both the standing of firms operating in the center and the willingness of strong firms to come to the center will be affected by the quality of regulation and supervision. There are at least three major consequences. First, a high-quality regulatory environment will have a positive effect on cooperation among the firms in the center, since all the firms will trust each other more than if the regulatory standards were suspect; the clustering gains from location in the center will accordingly be greater. Second, since firms outside the center will look favorably on building relationships with the firms and markets in the center, the possibilities for benefiting from global value chains (see below) will be great for all those in the center. Third, authorities in other countries will be less prone to imposing tight regulatory standards on dealings of their local firms and markets with firms and markets of the particular center under discussion; the cost of association with other centers will be thereby lowered. Despite the publicity accorded to the April 2009 communiqué of the G-20 meeting in London,16 the basic principles guiding regulatory frameworks did not really change. The vigilance in the application of those principles perhaps did intensify and, also perhaps, certain markets and organizations previously spared close supervision became subjected to more intensive scrutiny. For example, the G-20 members in the communiqué agreed: ‘to extend regulatory oversight and registration to Credit

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Rating Agencies to ensure they meet the international code of good practice, particularly to prevent unacceptable conflicts of interest’. Certain systemically important hedge funds also became subjected to regulation and oversight. Moreover, capital requirements of financial organizations were re-examined and somewhat tightened, which meant raising minimum capital in absolute terms or, at least, in relation to (risk-weighted) assets. Approaches to Regulation In general, most fundamentally, a regulatory environment must ensure that financial services firms are able to understand and to measure the risks they take from any given exposure, to find ways to contain exposure within tolerable and profitable levels, and to protect the solvency of the organization from adverse developments. There will, perhaps, always be a continuing debate over the role of the market as opposed to official regulators in ensuring optimal risk management by private firms, and the relative importance of oversight as opposed to strict regulation. An important objective is to have financial firms institute appropriate internal processes to manage financial risks in ways that are socially optimal. This debate will, most likely, continue. The reality is that the issues are complicated and financial markets and instruments will become more varied and complex as time goes by. From the perspective of the firm, one can visualize two stages in risk controls: (1) identifying, understanding, and measuring the risks; and (2) setting limits and controls to meet the risk-return objectives of the firm. Many different types of risks are identified in the literature and mentioned in Chap. 2. There are a number of reasons why development of clear risk-­ management techniques has become more important for financial firms in recent years. Perhaps primary among these is the complexity of financial markets and instruments, which enable firms to rationally strive for greater profits if they can manage the increasing risks involved. But this same financial environment, coupled with serious incidences of bankruptcies of clients and failures of financial organizations, has increased the vigilance of public authorities, leading them, often, to tighten regulations, strengthen supervision and oversight, and to develop worldwide standards to prevent regulatory arbitrage and cross-border transmission of financial crises. As it turns out, a certain degree of dissatisfaction with some of the regulatory initiatives has been an additional impetus motivating financial firms

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to develop techniques and approaches that would be superior (from a perspective of firms’ risk-return profiles) to regulatory standardized approaches. The intention is to convince the authorities to permit the firms to implement their own internal processes, with only oversight by the authorities. Many financial firms take the view that a ‘one size fits all’ policy is damaging to their optimal portfolio management and hence profits. For example, banks believe that the credit risk associated with a portfolio would be affected by the degree of portfolio diversification and the credit quality of the counterparties. Thus, it is difficult to come up with capital requirements without detailed analysis of a bank’s particular situation. There has, therefore, been serious debates on when and how to use internal models as opposed to the standardized approach; on when the market is a more socially optimal regulator of governance behavior than public authorities; and on how one goes about deciding an optimal regulatory regime and strategy. As regards the issue of use of internal processes, the prevalent view would seem to be, first of all, that banks (and where relevant other financial organizations as well) must have adequate resources (analytical capacity, database, and infrastructure) if they want to develop and maintain their own internal models and processes that regulators can trust, for example, in setting capital requirements. Financial firms could then have the satisfaction of being able to tailor capital requirements to the actual risks (including the effects of diversification and credit quality of counterparties) they face in their activities. Second, it is the prevalent view that backtesting of the models used in internal processes must take place and regulators must be informed of the results. In the trading area (and hence for market risk) the ideal seems to be daily backtesting.17 Third, the robustness of the model should be under constant review. Stress testing is, thus, usually recommended. The case for the market is really a case for flexibility and the view that, after all, financial organizations have an incentive to survive. From this perspective, market discipline can be effective in promoting good governance in financial firms. Clearly, market discipline is most effective when there is full and accurate information disclosure and transparency. In addition, the more sophisticated the pool of those who could monitor the management of financial firms—such as owners, depositors, customers, and rating agencies—the more effective one would expect the forces of market discipline to be.18

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Even with substantial market discipline, the case for regulation is, first of all, that from a micro point of view the actions of financial organizations could have certain adverse effects on third parties for which it is very difficult to structure property rights sufficiently to ensure internalization of costs and benefits. Second, from a macro point of view, the argument is that the soundness of the financial system is essential for systemic stability and economic growth of a country. This concern for the impact of individual players on financial stability could, in addition to regulation and supervision, also lead to a too-big-to-fail policymaking, which could be suboptimal in equilibrium because of incentive-conflicted behavior of regulators.19 As regards optimal regulatory regime and strategy, the general concern of public policy is having in place an appropriate regulatory regime and a consistent regulatory strategy to promote safety, efficiency, and stability in the financial system. Such a regime, among other things, will balance regulatory rules, supervisory review, and market discipline. One natural approach is to begin with a view of the components of a regulatory regime and to think of them as inputs to be combined in an optimal way to design and implement an appropriate regulatory strategy. This is essentially David Llewellyn’s approach spelled out in his 2002 paper.20 He argues that there are seven major components of a regulatory regime and an objective of public policy should be to combine, optimally, these components to design and implement an appropriate regulatory strategy. The seven components are: (1) the rules established by regulatory agencies; (2) monitoring and supervision by official agencies; (3) the incentive structures faced by regulatory agencies, consumers, and especially banks; (4) the role of market discipline and monitoring; (5) intervention arrangements in the event of compliance failures; (6) the role of internal corporate governance arrangements within financial firms; and (7) the disciplining and accountability arrangements applied to regulatory agencies. Llewellyn stresses the complementarity of the seven components and argues that the optimum mix would change over time as market conditions and compliance culture change. Llewellyn argues that several problems emerge with a highly prescriptive approach to regulation. For example, the risks under consideration may be too complex for simple rules; prescriptive rules may prove inflexible and not sufficiently responsive to market conditions; and the rules may have perverse effects in that they are regarded as actual rather than minimum standards. He stresses that a central issue is the extent to which regulation

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differentiates between different banks according to their risk characteristics and their risk analysis, management, and control systems. With respect to incentive structures, Llewellyn argues that a central role for regulation is to create appropriate incentives within regulated firms so that the incentives faced by decision makers are consistent with financial stability. At the same time, regulation should refrain from blunting the incentives of other agents (such as rating agencies, depositors, shareholders, and debt-holders) that have a disciplining role vis-à-vis banks. An important theme of Llewellyn is that regulation can never be an alternative to market discipline. On the contrary, regulation needs to reinforce, not replace, market discipline within the regime. On the question of intervention by regulatory agencies in the event of either some form of compliance failure within a regulated firm, or when financial distress occurs with banks, he argues in favor of a rules-based approach to intervention rather than discretion. This author believes that most experts agree that regulators should not rely solely on rules, as market discipline is often at least as important as—and sometimes even more so than—regulation. Also noted above are the conditions under which market discipline works effectively. On the other side of the coin, experts generally agree that regulators must be made accountable so that their decision-making truly reflects the public interest. Hence, the incentive structure within regulatory agencies is very important. In sum, how one determines, in practice, the balance between regulation, on the one hand, and market discipline, on the other, will be a major concern for the authorities in their approach to supervision and regulation of the financial center. The relative weights will indeed depend on the available expertise within financial firms and within regulatory agencies, the nature of the risks faced by the financial firms in the center, and the relative sophistication and efficiency of the pool of others who could ­monitor the management of financial firms—such as owners, depositors, customers, and rating agencies. Corporate Governance If one starts with the realization that the financial organizations under consideration will be operating in a developing country and that failures in the financial system have systemic economic effects, it is difficult to be concerned with only shareholder interests when looking at corporate

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governance of financial firms and markets. Indeed, even extending the concern to workers and other participants in the financial system is not enough. As stated in Chap. 2, these days, most experts in the field of corporate governance start from the view that a corporation is ‘a complex web or “nexus” of contractual relationships among the various claimants to the cash flow of the enterprise’.21 In the context of a developing country and of financial services firms, the duty of managers and directors should be broader than maximizing the value of the firm for shareholders. Loyalty of an organization’s officers to shareholders should not have external harmful effects on the larger community for which those shareholders do not pay. The beneficiaries of directors’ fiduciary duties (in particular, of care and loyalty) should extend beyond shareholders and include all persons in the community.

Organizational Structure in Supervision: Unified or Not An important issue in trying to develop an international financial center is whether there should be a unified supervisory agency or instead one should adopt various models of splintered agency arrangements.22 This author’s own view is that, for a country in the African continent, a unified approach would enable them to speed up their development of an international financial center, if they want one. A single, unified agency would have several advantages already discussed in Chap. 2.

Promoting the Center There are a number of ways that the authorities, the International Financial Services Development Council (IFSDC), and the Financial Area Corporation (FAC) can directly promote the financial center. In particular, the methods would comprise: (i) assisting the center to access global value chains, (ii) devising selective intervention policies that favor the center firms, and (iii) designing special enclave privileges for the center. Accessing Global Value Chains On can visualize the production process of some commodity or service as involving a ‘chain’ of activities beginning with the conceptualization of

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the product and ending with bringing the product to market. At each stage, ‘value’ is added to the chain. In addition, the chain can be cross-­ border. From such a perspective has emerged the now well-known concept of a global value chain. A major objective of those at the lower end of a chain is upgrading. Four types of upgrading have been identified in the literature and listed in the order they fall in the usual upgrading path: process upgrading, product upgrading, functional upgrading, and chain upgrading. Process upgrading involves increasing the efficiency of internal processes, making the firm more competitive in making existing products. Product upgrading involves introducing new products or improving old products. Functional upgrading involves changing the mix of activities conducted within the firm, or moving from low-return activities to high-return activities. Finally, chain upgrading occurs when the firm moves to a new and more profitable chain.23 In the modern world, standardized products and processes, electronic linkages, and internet connections all facilitate global chain relationships. One of the great advantages of accessing global value chains is the benefit of learning from others and hence the possibility of upgrading faster than otherwise. In this process, important are standards and the ability to meet buyer specifications. Indeed, formal benchmarking—measuring firm or cluster performance against specific product quality or productivity targets—is widely used in value chains. The lead firms in global value chains often will provide the benchmarks for their suppliers. A standard in this context would be a rule, normally for measuring quality or other aspects of production and performance in general. In the international financial center business, we see both major and minor value chain relationships all the time. For instance, early in its development, Singapore International Monetary Exchange (SIMEX) established a relationship with the Chicago Mercantile Exchange, which was valuable to both.24 Firms in Dublin, Hamilton, and the Channel Islands have links with firms in the City of London in niches where the first three are important. Noteworthy is that, to benefit from such global value chain arrangements, a new or developing international financial center must not only be attractive to other financial firms and markets abroad, but its governance and regulatory environment must also be respected by regulatory authorities of the leading financial centers. In addition, to facilitate such linkages, the authorities of a developing financial center can be proactive in making known their openness

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to joint ventures, 100 percent foreign ownership of firms, and to allowing foreign firms to participate in certain ‘sensitive’ activities in the local financial center—such as brokerage, underwriting, primary dealership in securities (especially government securities), and membership in the stock exchange. Moreover, the authorities and the IFSDC can assist the developing center’s firms in making contacts and structuring relationships with firms and markets abroad in order to motivate the global chains. Other Selective Intervention Policies There are other types of selective intervention policies that can promote the center by reducing operating costs of, and increasing demand for, the center’s services. First, the authorities can assist the center with market research, providing information on new products and other knowledge inputs as well as potential clients both domestically and abroad. Second, the authorities could assist in making available, to the firms, critical infrastructure and public services at lower costs than otherwise; for instance, leases, rentals, and user taxes could all be made lower than regular full-cost pricing would dictate. Third, the authorities can assist with finance, even if as credit rather than subsidies, for instance, to purchase equipment, train personnel, or implement innovation as mentioned already. Fourth, the authorities could make a special effort to patronize the center via demand for its services (fund management, for instance). Possible Enclave Privileges It may be very difficult for a new financial center in a country to make inroads into the global international financial center business, without being granted special enclave privileges, mainly because of the difficulties of building credibility with respect to microeconomic incentives and socio-political governance. As stated before, also, in the area of infrastructure and public services having a Financial Area Corporation (FAC) to attend to some of the tasks could be efficient and effective. For an enclave approach, in addition, special policies, practices, and procedures would be designed for the financial center in the areas of taxation, administrative barriers, and the legal environment discussed earlier. Dubai is a case in point where this strategy worked.25

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Conclusion In this chapter, we argue that the geographical area in which an international financial center is located must be attractive as a place where people want to live, work, and visit. In developing such an international financial center, a country can set up an International Financial Services Development Council (IFSDC) to help foster cooperation among the financial services firms and markets, the government, the central bank, and the regulatory authorities. We outline a strategy for developing such a financial center, which involves the following: (1) conceptualizing a financial center as a cluster; (2) finding a niche for entry at the international level; (3) enhancing competitiveness by building capacity, structuring incentives, and improving the quality of the national governance environment; (4) putting in place high-quality financial services supervision and regulation; and (5) promoting the center by assisting it to access global value chains, implementing other appropriate and beneficial selective intervention policies, and granting it some enclave privileges. Approaching the problem as trying to develop a cluster will encourage focusing the strategy on exploiting the collective efficiency advantages of clustering, namely fostering joint action and experiencing net positive externalities. The developers should find a niche for entry into the international arena, in terms of clientele, products, and providers. The point is that aiming to cover the whole world in all financial services would not be efficient. In many cases, there may be huge costs with little or no benefits. A financial center in a West African country, for instance, can find a niche in Africa beginning with the Economic Community of West African States (ECOWAS) countries. The clientele would include governments, public enterprises, financial firms and markets, private nonfinancial businesses, foreign companies with operations in Africa, and Africans in the Diaspora. When it comes to the products and providers, all the major categories of financial services and major providers of such services can be attracted to the center. The specific products would then be left to market forces, including the ingenuity of the service suppliers. Thus, services would include: (1) foreign exchange services; (2) loan syndication; (3) stock and bond issues in local and foreign-denominated currencies; (4) fund management of various sorts; (5) money management; (6) mortgage; (7) insurance; and (8) monitoring and rating services of firms, management, individuals, governments, and various kinds of securities and instruments. The providers, as a minimum, would be banks, a stock market, insurance

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companies, and rating organizations of various kinds. These highly diversified organizations can be supplemented by specialist organizations, such as mutual funds, investment trusts, leasing companies, factoring companies, credit rating agencies, professional service consultancies, and research and risk analyses services firms. Futures and options exchanges as well as commodity exchanges could follow a little later, if economically efficient to do so in the center. The idea is to encourage specialist firms and organizations to emerge or locate from outside to fill any important niche that would strengthen the cluster. The capacity of the financial center will be built by strengthening the institutions (rules governing behavior), organizations, and mechanisms in the country, to support: innovation in financial services; investing in appropriate human capital; raising financial capability of citizens, that is, the knowledge, skills, and motivation of the population to manage their finances; and putting in place appropriate physical and technological infrastructure. On infrastructure, the argument in the chapter is that the effectiveness and efficiency of the intended public sector contribution could be enhanced if a dedicated authority, a Financial Area Corporation (FAC), is created to provide some of the requirements of the financial center geographical area (cluster). The FAC could be given land and other capital to build and manage certain office space and perform any other functions that can be devolved to it with the agreement of the national and local authorities. The way the FAC finances itself—following the initial money, capital, and land grants—will depend on its duties. Structuring positive microeconomic incentives involves creating an open environment; keeping taxation at rates similar to those of competitors; keeping minimal the administrative barriers to investment and entry; and having a legal environment that is effective and efficient in its operations and is not more costly, to firms and individuals, in doing business for the center than the costs for similar activities in other competing centers. Openness, in particular, means that there is fair and open access to operate in the center; the types of business to be conducted by the same organization is not unduly restricted; innovation is encouraged; the authorities do not impose or modify rules without consultation with financial firms of the center; and there is freedom and flexibility allowed to firms in their day-to-day operations. The national governance environment has to do with macroeconomic policies, socio-political governance, and compliance with international standards and codes relevant for financial sector efficiency and stability. As

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regards macroeconomic stability, the attractiveness of the center will benefit from low inflation, stable (not fixed) exchange rates, capital mobility, and convertibility of the domestic currency or absence of exchange controls. With respect to socio-political governance, we argue that the authorities of the country trying to develop an international financial center should try to improve the country’s ratings in surveys and indices of risk of expropriation, general governance, constraints on the executive, and corruption. The authorities should design a plan to improve general governance—with clear objectives and instruments—make it transparent, and implement it resolutely. The discussion on regulation, supervision, and oversight cover approaches to regulation, corporate governance, the organizational structure for regulation and supervision, and the role of the central bank. We argue that, most fundamentally, the regulatory environment must ensure that financial firms are able to understand and to measure the risks they take from any given exposure, to find ways to contain exposure to tolerable and profitable levels, and to protect the solvency of the organization from adverse developments, given exposure. Regarding the balance between regulation, on the one hand, and market discipline, on the other, the relative weights will depend greatly on the available expertise within financial firms and within regulatory agencies, the nature of the risks faced by the financial firms in the financial center, and the relative sophistication and efficiency of the pool of others who could monitor the management of financial firms—such as owners, depositors, customers, and rating agencies. On corporate governance, we argue that the duty of managers and directors should be broader than maximizing the value of the firm for shareholders. Loyalty of the organization’s officers to shareholders should not have costly external economies for the community for which those shareholders do not pay. Hence, in exercising their fiduciary duties to their shareholders, financial services firms and markets should not act in ways that threaten the stability of the economy or reduce confidence in the financial system at large. On organizational structure for regulation and supervision, we argue that, for just about any African country, a unified approach would enable it to speed up its development as an international financial center. The argument is founded on efficiency—economies of scale in regulatory activity; the benefit of encouraging financial conglomerates for which unified supervision makes sense; the fact that products across subsectors are becoming more similar and hence directly competitive; that there will be

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little or no risk of financial services falling in-between cracks; that the gains from clustering and accessing global value chains will be better appreciated and hence facilitated by a single unified regulator; that foreign regulators also will have to deal with only one supervisory agency; and that the accountability problem is simplified. Even where there is unified supervision of financial services, by an agency separate from the central bank, the central bank will need up-to-­ date prudential information on the banks in connection with its lender-of-­ last-resort function, its role in the payment system, its foreign exchange rate policy and management, and even more importantly because of its primary responsibility, namely, the conduct of monetary policy. The national authorities, the International Financial Services Development Council (IFSDC), and the Financial Area Corporation (FAC) can directly promote the financial center. In particular, we mention that they can help the center access global value chains, devise selective intervention policies in the operations of the center, and design special enclave privileges for the center. The authorities will foster global value chain arrangements for the center firms via policies that make the center firms attractive to other financial firms and markets abroad and by the quality of the governance and regulatory environment. Selective intervention policies to promote the center can include assisting the center with market research and information on new products and other knowledge inputs; making available critical infrastructure and public services at lower costs, than otherwise; assisting with finance; and making a special effort to patronize the center via demand for its services.

Notes 1. See, for example, Huat et al. (2004), IBA Japan (2007), and Sanyal (2007). 2. In Germany, the government launched a drive for Finanzplatz Deutschland, which among other things they hoped would help promote nonbank financing and spark greater German interest in equities. It was essentially an alliance of the Deutsche Börse, the Bundesbank, the big banks, the City of Frankfurt, and virtually all the financial institutions, German and foreign, that operate out of Germany. The aims included a futures market, improved electronic links among regional markets, longer opening hours, and elimination of a German turnover tax on securities transactions. In France, Paris Europlace is an organization that helped in promoting Paris as a financial center. It represents the major players—investors, corporate

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issuers, brokerage firms, banking organizations, market authorities, as well as legal, accounting, and consulting firms and professional associations. Its mission has been to bring together all the players to promote and lobby (in France and Europe) for the French financial industry, as well as to foster reforms and design appropriate action programs to develop French financial markets, firms, and institutions. 3. IFSL is an independent, not-for-profit membership organization. Its membership is drawn from UK’s financial and related businesses, including banking, insurance, trading exchanges, regulatory bodies, and professional services. IFSL is the designated private sector partner of UK Trade & Investment and the Corporation of the City of London for international promotion of UK financial services. It is involved in research, providing analysis and statistics that, among other things, inform on UK’s role in international financial markets; it works for greater liberalization of trade in financial services; and it facilitates contacts and opportunities for their members. 4. Depth has to do with size of a financial market/organization relative to a relevant variable such as gross domestic product (GDP). Liquidity has to do with the value of financial assets traded in the financial market, during some time period, relative to, say, GDP; alternatively, liquidity is the value of the assets traded, in the financial market, during some time period, relative to the total value of the assets of the market. 5. The main focus of cluster analyses has been the industrial sector; see, for example, Oyelaran-Oyeyinka and McCormick (2007) and Yusuf et  al. (2008). But the analysis applies in general. In traditional growth and development analyses, ‘agglomeration’ rather than ‘cluster’ is the term of choice. 6. See, for example, Levine (1997). 7. For the African economic communities, see Johnson (2016). 8. In its argument urging the Japanese authorities to remove certain firewall restrictions, the IBA Japan (IBA Japan 2007, p.  15) argued as follows: ‘IBA financial conglomerate members currently encounter the following problems due to the firewall restrictions in Japan; (1) inefficiencies due to the overlapping of human resources, organizational structures, and systems; (2) constraints on effective and efficient business management practices, including the formulation and implementation of business strategies and risk management at the group level; and (3) constraints on providing comprehensive financial services that would maximize customer convenience.’ Note that a financial conglomerate could, for example, conduct banking, securities, as well as other financial services business. 9. A similar point has been made by Sanjeev Sanyal (2007) in the context of Mumbai.

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10. There are three tests: the independent capacity test, the 20 percent test, and the customary rate test. The independent capacity test specifies conditions under which the relationship between the UK manager and the nonresident is considered independent. The 20 percent test requires that the investment manager and persons connected with it, including connected charities, must not have a beneficial entitlement to more than 20 percent of the nonresident’s chargeable profit arising from transactions carried out through the investment manager. The customary rate test specifies that the UK investment manager ‘must receive remuneration at a rate that is not less than customary for the services.’ 11. See, for example, the discussion in Sundararajan et al. (2002). 12. See Johnson (2002). 13. See, for example, Välilä (2002) for a discussion on the basic analytical issues involved in considering fiscal support. 14. In a sense, building credibility for political stability is easy; also, evidence on political stability is much easier to observe than evidence on corruption and good governance. 15. See the discussion in Johnson (2007), pp. 155–161. 16. See G-20 (April 2009). 17. See, for example, Crouhy et al. (1998). 18. See also Llewellyn (2002) on this point. 19. See Kane (2002). 20. Llewellyn (2002). 21. Macey and O’Hara (2003). 22. See, for example, Abrams and Taylor (2000). 23. See Gereffi and Korzeniewicz (1994) and Oyelaran-Oyeyinka and McCormick (2007). 24. See Lee Kuan Yew (2000), p. 77. As Lee Kuan Yew puts it, they ‘convinced the CME to adopt a mutual offset system with SIMEX that enabled roundthe-clock trading. This revolutionary concept allowed an investor to establish a position at CME in Chicago and close off at SIMEX in Singapore, and vice versa, without paying additional margins. The U.S. Commodity Futures Trading Commission approved this arrangement.’ 25. Sanyal (2007) also suggests a ‘custom-built’ enclave for Mumbai financial center.

References Abrams, Richard K., and Michael W. Taylor, 2000, “Issues in the Unification of Financial Sector Supervision,” International Monetary Fund Working Paper, WP/00/213, December.

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Crouhy, Michel, Dan Galai, and Robert Mark, 1998, “The New 1998 Regulatory Framework for Capital Adequacy: ‘Standardized Approach’ versus ‘Internal Models’,” in Risk Management and Analysis: Vol. 1. Measuring and Modelling Financial Risk, edited by Carol Alexander (New York: John Wiley & Sons), pp. 1–37. G-20, 2009, “The Global Plan for Recovery and Reform,” Final Communiqué, London, April 2. Gereffi, Gary, and Miguel Korzeniewicz (editors), 1994, Commodity Chains and Global Capitalism (Westport, CT and London: Praeger). Global Financial Centres Index 24, 2018 (City of London: Z/Yen Group Ltd), September. https://www.zyen.com/publications/public-reports/globalfinancial-centres-index-24/ HM Treasury, 2007, “Financial Capability: The Government’s Long-term Approach,” (London: HM Treasury), January. https://dera.ioe.ac.uk/7551/ 1/fincap_150107.pdf Huat, Tan Chwee, Joseph Lim, and Wilson Chen, 2004, “Competing International Financial Centers: A Comparative Study between Hong Kong and Singapore.” http://www.nus.edu.sg/sawcentre/docs/competing%20international%20 financial%20centers-%20comparative%20study%20between%20hong%20 kong%20and%20singapore.pdf International Bankers Association, Japan (IBA Japan), 2007, “Recommendations to Promote Tokyo as a Global Financial Centre,” March 16. https://www.fsa. go.jp/singi/singi_kinyu/s_group/siryou/20070323/04.pdf Johnson, Omotunde E.  G., 2002, “Comment on: ‘On the Welfare Costs of Systemic Risk, Financial Stability, and Financial Crises’,” in Financial Risks, Stability, and Globalization, edited by Omotunde E. G. Johnson (Washington, DC: International Monetary Fund), pp. 229–238. ———, 2007, African Economic Development: Cooperation, Ownership, and Leadership (Lewiston, Queenston and Lampeter: The Edwin Mellen Press). ———, 2016, Economic Diversification and Growth in Africa: Critical Policy Making Issues (Palgrave Macmillan). Kane, Edward J., 2002, “Dynamic Inconsistency of Capital Forbearance: Long-­ Run Versus Short-Run Effects of Too Big to Fail Policymaking,” in Financial Risks, Stability, and Globalization, edited by Omotunde E.  G. Johnson (Washington, DC: International Monetary Fund), pp. 320–339. Lee Kuan Yew, 2000, From Third World to First—The Singapore Story: 1965–2000 (New York, NY: Harper Collins Publishers), Chapter 5 “Creating a Financial Center.” Levine, Ross, 1997, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35, no. 2 (June), pp. 688–726. Llewellyn, David T., 2002, “Alternative Approaches to Regulation and Corporate Governance in Financial Firms,” in Financial Risks, Stability, and Globalization,

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edited by Omotunde E. G. Johnson (Washington, DC: International Monetary Fund), pp. 117–163. Macey, Jonathan R., and Maureen O’Hara, 2003, “The Corporate Governance of Banks,” FRBNY Economic Policy Review, Vol. 9, no. 1, pp. 91–107. Oyelaran-Oyeyinka, Banji, and Dorothy McCormick (editors), 2007, Industrial Clusters and Innovation Systems in Africa (Tokyo, New York and Paris: United Nations University Press). Sanyal, Sanjeev, 2007, “Building an International Financial Center in Mumbai,” Asia Economics Special, Deutsche Bank, Global Markets Research, June 15. ̇ Sundararajan, V., Akira Ariyoshi, and Inci Ötker-Robe, 2002, Financial Risks, Stability, and Globalization, edited by Omotunde E. G. Johnson (Washington, DC: International Monetary Fund), pp. 426–472. Välilä, Timo, 2002, “Fiscal Support in Financial Sector Restructuring: Analytical Issues,” in Financial Risks, Stability, and Globalization, edited by Omotunde E. G. Johnson (Washington, DC: International Monetary Fund), pp. 347–376. Yusuf, Shahid, Kaoru Nabeshima, and Shoichi Yamashita (editors), 2008, Growing Clusters in Asia: Serendipity and Science (Washington, DC: The World Bank).

Index1

A Accountability problem, 41, 134 Administrative barriers, 5, 27, 29, 130, 132 Austria, 70n39 Automated Teller Machine (ATM), 21 B Backtesting, 125 Banker’s acceptances (BAs), 46, 48, 68n26 Bank of England, 68n24 Bank of International Settlements (BIS), 5, 20, 86 Behavioral economics, 95, 96 Bill & Melinda Gates Foundation, 70n39 Bourse Regional Des Valeurs Mobilière (BRVM), 51, 66n9

C Capacity building, v, 4, 5, 14, 22–26, 89, 112–113 Capital Asset Pricing Model, 100n3 Capital buffers, 20, 59, 66n10 Capital market, v, vi, 5, 14, 44, 49–53, 61, 104 Capital mobility, 28, 31, 67n16, 96, 99, 118, 120, 121, 133 Certificates of deposits (CDs), 46, 48 Classical risks, 21 Cluster, vi, vii, 7, 11, 106–109, 111–113, 129, 131, 132, 135n5 Collateral, 3, 30, 34, 45, 49, 61, 66n12 Commercial paper, 46, 48 Conglomerates, 41, 68n25, 115, 133, 135n8 Consultative Group to Assist the Poor (CGAP), 62, 70n39

 Note: Page numbers followed by ‘n’ refer to notes.

1

© The Author(s) 2020 O. E. G. Johnson, Financial Sector Development in African Countries, https://doi.org/10.1007/978-3-030-32938-9

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INDEX

Corporate governance, 5, 38–39, 42, 50, 68n23, 68n25, 104, 112, 126–128, 133 Credit bureau(s), 13 Credit rating, 16, 32, 45, 66n11, 66n12, 122 Credit rating agency, 21, 55, 112, 124, 132 Credit rating systems, 45 Credit scoring systems, 66n12, 67n12 Credit unions, 59 D Deposit collectors, 63 Digital banking, 53, 70n35 Discount window policy, 47 E Early warning signals, 5, 40 Enclave privileges, 7, 107, 128, 130, 131 European Investment Bank, 13, 66n7 Exchange rate regime, 6, 82, 83, 92, 93 Expert systems, 21, 66n12 External economies, 107, 109, 133 F Financial Area Corporation (FAC), 116, 119, 128, 130, 132, 134 Financial capability, 5, 23, 25–26, 113, 132 Financial center, 6, 7, 23–25, 27, 28, 30, 31, 103–134, 134n1 Financial conglomerates, 41, 133, 135n8 Financial inclusion, 1, 3–6, 18, 19, 21, 22, 34, 53–56, 65n6, 70n36, 70n37 Financial intelligence capacity, 3, 34

Financial market intervention policy making (of the central bank), 98 Financial Services Authority (FSA) in UK, 68n24 Financial Stability Board, 39 Financing of terrorism, 3, 22, 34 Firewalls, 27, 109, 117, 135n8 Foreign exchange market, 2, 6, 15, 18, 28, 79–100, 104, 111 G Ghana Alternative (Stock) Market (GAX), 69n33 Global value chains, 7, 42, 107, 123, 128–131, 134 Governance structures, vi, 4, 13, 65n2, 93 H High-powered money, 87 Human capital, vii, 4, 5, 11, 14, 21, 23–25, 27, 28, 92, 113–115, 117, 118, 132 I Illegal financial transactions, 3, 34 Innovation system, 4, 5, 14, 21, 23–24, 113–114 Insurance, vi, 11, 14, 17, 24, 54, 64, 94, 104, 109, 111, 131, 135n3 Interbank market, 46, 47 International Financial Services Development Council (IFSDC), 109, 110, 112, 128, 130, 131, 134 International Monetary Fund (IMF), 4, 53, 92 International standards and codes, 5, 16, 30, 33–34, 120, 122–123, 132

 INDEX 

Investment banking, 52, 53 Ireland, 42 L Legal environment, 5, 27, 29–30, 117, 119–120, 130, 132 Lombard facility, 47 M M-Akiba, 56 Malaysia, 70n37 Mali, 60, 66n9 Marginal efficiency of investment, 4, 14, 50 Market discipline, 15, 36, 37, 125– 127, 133 Menu effects, 96 Microcredit, 60–61, 63 Microeconomic incentives, 5, 26–30, 80, 116–117, 130, 132 Mobile money, 13, 15, 55–57, 59, 63, 70n35, 70n38 Money laundering, 3, 22, 34, 89 Money market, vi, 5, 14, 20, 44–48, 87 N National coordination council, 109 National macroeconomic governance framework, 98 National social security and insurance systems, 62 National social welfare, 6, 95 Net foreign asset (NFA), 87 Niche, vi, vii, 7, 106, 108, 110, 113, 129, 131, 132 O Open environment, 27, 117, 132

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P Payment system, vi, 5, 13, 14, 21, 22, 31, 42, 44, 48–49, 121, 134 Policy environment, 12, 13, 26, 27, 30, 52, 80, 96–97, 100, 116, 120 Policy implementation organizational framework, 98 Post Office Savings Bank (POSB), 63 Promotion, 39, 52, 59, 106, 135n3 R Regulation, vi, vii, 3, 7, 13, 15, 16, 18, 22, 31, 35–38, 43, 65n6, 80, 89, 93, 97, 106, 112, 121, 124–127, 131, 133 Regulators, 10, 13, 14, 23, 33, 35, 36, 41, 42, 59, 65n2, 65n6, 68n24, 97, 107, 122, 125–127, 134 Regulatory strategy, v, 5, 14, 34–43, 126 Regulatory systems, 5, 56 Reserve requirement policy, 47 Reuters, 71n41 Risk controls, 40, 49, 124 Rotating savings and credit associations (ROSCAs), 55, 59 S Safaricom, 70n35 Secondary bond market, 52 Securities and Exchange Commission (SEC), 50, 51 Selective intervention, vii, 4, 6, 7, 14, 15, 44, 80, 86, 98–100, 107, 128, 130, 131, 134 Social efficiency, v, 6, 17, 80–86, 91, 92 Socially efficient market equilibrium, 81

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Socio-political environment, 83 Socio-political governance, 5, 30, 32, 120–122, 130, 132, 133 South Africa, 6, 19, 42, 52, 53, 65n6, 66n8, 104, 122 Spontaneous order, vi, 10 Stock Exchange, 19, 20, 50, 51, 66n9, 68n21, 69n32, 130 Stock market, 5, 6, 10, 11, 13, 19, 49–52, 68–69n30, 69n32, 69n33, 104, 111, 131 Stress testing, 3, 43, 125 Supervision, vi, vii, 3, 4, 7, 13, 18, 19, 22, 38–43, 48, 65n6, 86, 92, 100, 106, 109, 112, 124, 126–128, 131, 133, 134 Supervisors, 13, 35, 40, 42, 59, 107 Syndication, 52, 111, 131 Systemic fundamentals, 4, 6, 11, 14, 15, 21, 65n2, 80, 81, 96

T Taxation, vii, 5, 13, 24, 25, 27–29, 89, 115, 117–119, 130, 132 Tiered regulation, 43 Transaction costs, 17, 18 U US, 98 US Federal Reserve, 37 V Value chains, 7, 42, 107, 123, 128–131, 134 W World Bank, 4, 12, 54, 67n20, 70n37, 70n39