Tuesday, September 28, 2021

Efficient financial services sector spurs high economic growth

The efficiency of the banking system, that essentially provides the most basic of the financial services sector component, is critical for any modern economy, not only in terms of turnover, but also as the primary financier of the national economy.

It is generally accepted that the financial sector development is central to economic development and that inclusive financial systems are important for inclusive development.

The positive impact of the financial sector development on economic performance is also supported by evidence from Africa, “although the results are not as strong mainly due to weak quality of the available data”.

A 2017 research article titled “Financial Sector Development in Africa: An Overview” reckons that “a more liberalized financial environment has emerged in Africa because of financial sector reforms. These reforms have been stimulated by rapid improvements in global conditions and global technology connecting Africa with the outside world. Therefore, it is not accidental that Africa began to experience good performance both in the real and financial sectors”.

According to the research study, until recently, “Africa experienced uninterrupted growth for two decades, and was for many years one of the highest growth regions”, as pronounced by the World Bank in 2013. It is also interesting that even stock markets began performing impressively.

Prior to the financial crisis period, African stock markets performed surprisingly well in terms of both absolute stock return and on a risk-adjusted basis despite the challenges they had faced in terms of low capitalization and liquidity.

Moreover, there are currently encouraging forces in play for the prospect of Africa to integrate into the global financial economy. There is growing integration of world capital markets, including those in emerging economies, with increasing capital mobility.

Barriers to international capital flows have been reduced.  Also, there are rapid advances in information technology connecting Africa with the outside world, allowing outside investors seeking the benefits of global diversification to be better able to access African financial systems.

Despite this impressive performance both in terms of financial sector reforms and economic growth, financial markets in Africa are considerably less well-developed than elsewhere in the world on virtually all measures of financial development.

In fact, the financial sectors of most African countries remain quite underdeveloped even by the standards of other peer low income countries, and the African financial development gap is huge; so is the financial inclusion gap.

The development gap pertains to both banking and non-bank systems. In the non-bank finance area, for instance, based on the standard measures of trading activity and capitalization, most African stock markets are quite thin with low level of liquidity, and there are now ongoing initiatives to build regionally integrated stock markets.

“Notwithstanding its less developed status, the African financial markets weathered the crisis remarkably well, especially when compared to other developing regions”, states the research study adding that “the global financial crisis was a rude awakening around the world, including Africa”.

It revealed severe regulatory gaps and distorted incentives in the banking and overall financial system, which lead to build-up of risk exposures not only by banks but “shadow banks”.

This spurred renewed efforts to enhance the resilience of the financial sector by reducing the frequency and severity of future crises through, among other things, the introduction Basel III accord.

Moreover, apart from capital standards, there are now standards for supervision and monitoring of bank liquidity, which typically arises from a mismatch between short term bank liability and long term assets.

“Financial sector regulators in Africa have also embraced the some elements of Basel III to strengthen their financial sectors through beefing-up regulatory capital, improving risk management and governance etc,. However, the other challenges faced by African policy makers include the need to enhance financial broadening through inclusion, as well as financial deepening”, states the research study.

The study also found positive competition impacts among foreign banks and surmise that this could be due to the fact that foreign banks may obtain additional capital at concessional rates from their parent companies and thus do not bear the full brunt of the costs arising from higher regulatory capital requirements, unlike domestic banks that have to source the additional capital on the open market. The higher costs faced by domestic banks are passed on to consumers, resulting in reduced competitiveness of domestic banks.

Regarding the impact of increasing regulatory capital on financial sector stability, the authors found that raising the regulatory capital requirement “increases instability in the African banking sector. However, the big banks do not experience instability”.

A concerning finding by the research study is that “consequently, banks hold less regulatory capital than they are supposed to given their risk profiles. This explains the instability”, and the authors conclude that “raising regulatory capital may not be sufficient to mitigate financial sector instability in the African banking sector and that additional measures may be needed.

The authors further conclude that the nature of ownership of banks and bank size matter for the impact of regulatory capital on competition in the banking sector.

Another research study titled “The Financial Sector and The Role of Banks in Economic Development” explains that a bank can be associated with a financial service conglomerate able to provide basic and properly function within the economic, political, legal and international environment that determines its profit and expansion opportunities, interest rates, exchange rates and the particular resources a bank need.

The efficiency of the banking system is a key determinant of sustainable growth. Thus, banks are essential for any modern economy, not only in terms of turnover, but also as the primary financier of the national economy.

Altogether, banks channel savings into productive capital, facilitate productive use of surpluses to generate employment and promote economic welfare and provide risk-free income to depositors.

The research study concluded that banks as financial intermediaries are expected to provide basic financial services for everyone. Banking, considered as a mirror of economic growth, can contribute to economic development directly by increasing balance sheet items and indirectly through financing.

In the global economy, the growing importance of banks is obvious, given that in the context of accelerating the development of information systems and communications as the global world witnesses the emergence of global financial networks.

Many researchers argue that a sound and efficient banking system is significant in achieving economic development. Thus, “well functioning banks accelerate economic growth, while poorly functioning banks are an obstacle to economic progress and aggravate poverty”.

It is also reckoned that “the separation between finance and economic growth may be only temporary since better access to finance can help existing firms to grow and new firms to enter the market, which in turn supports growth at the aggregate level”.  

Yet another 2018 research study titled “The Role of Financial Sector on Economic Growth: Theoretical and Empirical Literature Reviews” found that “interaction term of foreign direct investment and indicators of financial development affect economic growth positively. Though this effect tends to exist only at a given threshold level of financial sector development in host countries”.

In low-income countries, more financial development without sound institutions may not succeed in delivering long-run economic development. Both financial sector size and efficiency is a good mediator in generating growth.

This is due to higher efficiency financial sector enhances the use of productive financial capital which results in generating high growth. Likewise, the more and well-functioning financial sectors have an ability to spend financial capital in efficient ways.

Financial development influences growth through all channels. Specifically, ideas production is found to be the most important channel through which financial development impacts on growth.

This particular study concluded that “the impact of the financial sector is more significant and positive to the developing countries compared to developed countries”.

A 2014 research study titled “Banking Sector Development and Foreign Direct Investment: A case of Botswana” also acknowledged that well developed and functioning financial markets not only do they facilitate FDI inflows into the host country but they also ensure that the host country benefits from those FDI inflows.

In the case of Botswana which is characterized by a relatively small size of the banking sector and which heavily relies on FDI for economic prosperity, “the directional causality between FDI inflows and banking sector development requires a thorough scrutiny”.

The study also found that banking sector development attracts FDI inflows into the host country and the second perspective suggests that there is a positive feedback effect between banking sector development and FDI inflows whilst the third perspective maintains that there is no causality relationship between the banking sector development and FDI net inflows.

The study confirmed that the long run relationship between the banking sector development and FDI net inflows is an indirect one and the two sets of variables affect each other indirectly through other factors in Botswana.

The study urges Botswana authorities “to boost banking sector development or rather to design and implement policies that can help Botswana banking sector to attract more FDI net inflows”, which are also an essential ingredient for economic development.

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