Africa’s growth tragedy is at least partially explained by financial under development (Easterly and Levine 1997). Africa remains today one of the most financially under-developed parts of the world. Financial under-development is frequently associated with a country’s inability to mobilise sufficient amounts of saving to satisfy the demand for credit. A recent study by the World Bank has, however, shown that African banking systems, although lacking in depth compared to other regions in the world, are excessively liquid (Honohan and Beck 2007). That is to say, savings mobilisation does not appear to represent a binding constraint on African banks’ ability to lend. Instead, African banks complain of a lack of credit worthy borrowers while at the same time households and firms complain about lack of credit. The same study shows that the least developed banking systems in Africa are also the most liquid, which implies that resolving the paradox of excess liquidity may hold the key to understanding African financial under-development. To do so requires focussing on the structure and mechanics of African credit markets.
The main contribution of this paper is to put forward a plausible explanation of African financial under-development in the form of a bad credit market equilibrium the ‘African credit trap’. We show that the root of the problem could be either moral hazard—taking the form of strategic loan defaults—or adverse selection emanating from the lack of good projects. Theoretically, the two are almost indistinguishable but we make an attempt to gauge empirically which of the two is the most likely cause.
The first part of the paper is theoretical. It modifies a standard IO model of banking to analyse the market for bank credit. The model encapsulates various stylised facts of African credit markets, including high loan default rates. In the model, sub-optimal equilibria arise when there are severe informational imperfections and institutions intended to contain moral hazard are weak. In these sub-optimal equilibria, the loan default rate ( an endogenous variable in the model) is high, which deters the expansion of bank credit. When we use the model to explore the impact of improvements in institutions designed to mitigate informational imper-fections, we find important non-linearities in the response of the banking system. For example, improvements in contract enforcement can reduce the impact of loan default on lending, but only when enforcement is low to begin with. Once the quality of contract enforcement has reached a certain level, further improvements will have no impact on banks’ behaviour. These results appear in both the moral hazard and adverse selection versions of the model, and are consistent with the threshold effects implicit in other macroeconomic studies.
The second part of the paper is empirical. It is aimed at testing various specific predictions of the theory utilising panel data for hundreds of African banks over a ten year period. Specifically, it explores the relationship between the amount that African banks are willing to lend, loan default rates and the institutional environment, allowing for threshold effects. The model is fitted using a dynamic panel estimator (Arellano and Bond 1991, Blundell and Bond 1998). Our empirical results provide strong support for the predictions of our theoretical model, and we are able to identify a threshold effect in regulatory quality. Moreover, they pass a variety of robustness checks, including sensitivity to different values of the threshold level as well as alternative dynamic panel data estimators. Finally, we provide some evidence on whether the root cause of the African credit trap lies in strategic loan default (moral hazard) or the lack of good projects (adverse selection).
Our paper complements a growing literature on African financial systems that is mainly macroeconomic in approach. Honohan and Beck (2007) provide the starting point for our paper in the sense that we delve further into some of the issues they raise in their important World Bank study. More recently, Allen, Otchere, and Senbetm (2010) provide a comprehensive, thorough and up-to-date overview of African financial systems, including banks, financial markets and microfinance. Their survey confirms the dominance of traditional banking over other forms of formal finance, particularly in Sub-Saharan Africa. It also suggests that the banking sector, which remains under developed, is dominated by state-owned banks or a few, frequently foreign owned, banks. It also highlights the tendency of African banks to invest in government securities but does not address the factors that explain excess liquidity. Other studies explore the links between financial development and economic growth in Africa.
Gries, Kraft, and Meierrieks (2009), for example, find limited support to the finance-led growth hypothesis in 16 Sub-Saharan African countries. Earlier work on a broader range of developing countries by Demetriades and Law (2006) shows that this is predominantly a feature of low income countries, most of which are, in fact, located in Sub-Saharan Africa. In middle income countries, some of which are located in North Africa, the link between finance and growth is much stronger. Similar threshold effects in the finance-growth relationship have also been documented by Rioja and Valev (2004). Such macroeconomic effects are consistent with our own findings of threshold effects in bank credit that are derived from a micro-setting.
The paper is structured as follows. Section 2 sets out the theoretical model and describes various credit market equilibria under moral hazard and adverse selection. Section 3 outlines the empirical model, describes the data set and explains the estimation method. Section 4 presents the empirical results. Section 5 summarises and concludes.
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