ABSTRACT
The study uses data spanning from the period 1996-2017 with random effect model to investigate the impact of credit risk on banking sector deregulation in West Africa. Two main objectives were addressed. First, the determinants of credit risk. Second the effect of credit risk on banking sector deregulation. The key determinants of the credit risk include return on equity of banks, financial system deposit to GDP ratio and bank assets to GDP ratio. The findings show that return on equity positively and significantly increases credit risk of banks in West Africa. However, we find that financial system deposit and bank assets to GDP negatively and significantly reduce credit risk in West Africa. We did not find any significant impact of macroeconomic indicators such as gross domestic product and inflation in our model. With respect to the impact of credit risk on deregulation, the study finds positive and significant effect of credit risk on deregulation in West Africa. This means that higher credit risk could necessitate deregulation of the financial sector in West Africa. Other bank specific variables we found to relate positively and significantly with deregulation include liquid liabilities to GDP, net interest margin and bank z-score. Similarly, the inclusion of the macroeconomic variables into the model improves on the performance of the model. The liquid liabilities as a percentage of GDP became positive and significant as well. The study makes some useful recommendation for policy and future research direction.
CHAPTER ONE INTRODUCTION
Background to the Study
Over the past few decades, many developing countries have focused on reducing or eliminating government control in the financial services sector. The major purpose was to stimulate economic development through removal of controls on interest rates and the allocation of credit and also encourage competition, efficiency and innovation within the sector (Pill & Pradhan, 1997). In another study by Abbas and Malik (2008) they showed that following state-level deregulation of the banking sector in Pakistan, the sector became more competitive with the introduction of innovative products in retail banking mainly to attract customers. In effect banks were able to enhance earnings by lowering their cost of funds generation. Also, Stiroh and Strahan (2003) demonstrated that following the removal of state-level restrictions on branch expansion, the United States’ economic boom accelerated. In addition to faster growth, macroeconomic stability improved with interstate deregulation of the banking sector.
However, Isibor, Ojo and Ikpefan (2017) argued that deregulation on its own does not necessarily translate to better performance by the banks, except when it is combined with other regulatory policies focused on promoting financial inclusion and protecting the interests of consumers. In addition, De Grauwe (1987) mentioned that following the economic challenges faced by governments of developing countries in exercising policies in favour of financial repression (the opposite of financial deregulation), there is now a widespread consensus among development economists of the macroeconomic benefits developing countries stand to gain from liberalizing their financial markets given that there are appropriate policies to protect the consumer from the effects of market failures.
The era of unfettered government intervention in the economy led in many situations to economic inefficiency rather than enhancing market performance (Stiglitz, 1998, cited in Adams & Agbemade, 2012), In addition, the socioeconomic environment prevailing in many of the developing countries under a financially repressive regime gave proof to the claim that distortions in interest and foreign exchange costs from government intervention could limit the real size of the financial system and by extension, economic growth (Shaw & McKinnon, 1973, cited in Adams & Agbemade, 2012) In effect financially repressive policies contributed to the retardation of the economic development process in many developing nations as was once evidenced in Ghana for the duration of the 1970s and the 80s (Antwi-Asare & Addison, 2000). According to Adams and Agbemade (2012), it was in response to the inefficiencies and unfavourable economic costs created through a financially repressive regime that the government was compelled to liberalize the financial system. The liberalization programme sought to deepen financial markets and additionally to promote economic growth.
In the early 1980s the wave of government control in the financial sector in most Africa countries began to fall due to the adoption of the Financial Sector Adjustment Programme (FINSAP). The weaknesses in the banking sector such as low competition, weak financials, low profitability, high non-performing loans (NPLs) and mortgages, poor liquidity of banks, low level of technology and low capital base was addressed through the financial sector adjustment program (Nabieu, 2013). According to Ackah and Asiamah (2014), Ghana’s financial sector reforms have yielded many gains for the country’s financial system. Today the country has a more diversified financial system as a result of the privatization of state-owned banks and the increased competition introduced by the influx of several new banks many of which are foreign-owned banks. In addition, the country’s banking industry has evolved to accommodate changes in the global and domestic macroeconomic environments along with technological and financial innovation.
The banks across the West African region have gone through various forms of liberalization with most countries making changes to their laws regarding the entry of foreign-owned banks. This has allowed many banks to expand into other countries within the West African region. Following the consolidation of banks in Nigeria in 2005, which saw the reduction of the banks from 89 banks to nearly 25 banks, the banking sector was strengthened thereby positioning some 14 Nigerian banks to be among the global top 1000 banks. During this period, Nigerian banks that needed offshore licensing required a minimum of $636 million as capital. This led to most of the Nigeria banks such as Access bank, Zenith bank, United Bank for Africa, GT Bank and others expanding into other West African countries. These banks also made inroads in other parts of Africa and the world as a whole. Seeing the success of this, Ghana followed suit by increasing the minimum capital requirements in 2009 from GHS7 million to GHS60 million. It was again raised to GHS120 million and with the recent re-capitalization of banks in 2018, it was pegged at GHS400 million. These revisions in banking capitalization are meant to make the banks sound and resilient for a successful take off in transforming the economy. Furthermore, in consolidating gains made in creating a robust banking sector, The Bank of Ghana set up a process to develop a framework of risk-based approach to supervision with a sharp focus on solvency and understanding the financial conditions of the individual banks. The aim of this is to ensure that Bank of Ghana better assesses the risks faced by the banks and be proactive in forestalling emerging problems in the banking industry. Apart from Ghana and Nigeria, other countries within the West-African sub-region have made various strides in developing their banking sectors since banks serve as the life blood of the economy.
Ahmad & Burki (2016) described financial deregulation as measures focused on allowing interest rates to be determined by market forces, promoting development of financial institutions, extending credit and deposit facilities, developing secondary markets for financial
instruments and encouraging competition among financial institutions. Chigbu, Ubah and Chigbu (2016) described deregulation in the petroleum sector as reducing the role of government as the owner and operator of assets in the sector while maintaining an active role as a policy maker and regulator. In applying this to the financial sector, this means a reduced government presence coupled with its role of protecting public interest within the financial sector. Merriam-Webster’s Dictionary defines deregulation as the act or process of removing restrictions and regulations. The Oxford Dictionary defines it as the removal of regulations or restrictions, especially in a particular industry. Izibili and Aiya (2007) cited in Kuye (2012) defined deregulation as doing away with the regulations concerning financial markets and trades. Eme and Onwuka, (2011) explained deregulation in the economic sense as allowing market forces to determine prices. Semaan and Drake (2011) postulated that in theory deregulation has to do with opening up an industry to competition. According to them, this competition should stimulate innovation and the development of products that benefit customers.