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«77246 Public Disclosure Authorized THE WORLD BANK ECONOMIC REVIEW, VOL. 11, NO. 2 195-218 Financial Market Fragmentation and Reforms in Ghana, ...»

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Public Disclosure Authorized


Financial Market Fragmentation and Reforms

in Ghana, Malawi, Nigeria, and Tanzania

Ernest Aryeetey, Hemamala Hettige, Machiko Nissanke, and William Steel

This article reports the findings from surveys of formal and informal institutions and

their clients in Ghana, Malawi, Nigeria, and Tanzania. It investigates the hypothesis

Public Disclosure Authorized that reforming financially repressive policies would not be sufficient to overcome fragmentation of financial markets because of structural and institutional barriers to interactions across different market segments. The four countries have substantially fragmented financial markets, with weak linkages between formal and informal segments and interest rate differentials that cannot be adequately explained by differences in costs and risks. Nevertheless, the relatively low transaction costs and loan losses of informal institutions indicate that they provide a reasonably efficient solution to information, transaction cost, and enforcement problems that exclude their clients from access to formal banking services. The findings imply that financial liberalization and bank restructuring in the African context should be accompanied by complementary measures to address institutional and structural problems, such as contract enforcement and information availability, and to improve the integration of informal and formal financial markets.

Public Disclosure Authorized Expecting to hasten financial deepening and reduce fragmentation of financial markets, governments in many Sub-Saharan African countries initiated financial policy reforms in the 1980s. This article examines the experience in four countries and raises the issue of whether policy reform programs need to be accompanied by measures to address the institutional and structural problems of financial s

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196 THE WORLD BANK ECONOMIC REVIEW, VOL 11, NO. 2 The countries studied—Ghana, Malawi, Nigeria, and Tanzania—have similar types of financial systems but different degrees of financial development and liberalization, permitting cross-country comparisons.

The analysis distinguishes between efficient specialization for market niches by different segments of informal and formal finance and fragmentation with impediments to efficient intermediation. Under efficient specialization for differentiated risk and cost characteristics, interest rate differentials reflect differences in cost of funds, transaction costs, and risk. In fragmented markets, wide differences in risk-adjusted returns occur because funds and information do not flow between segments, and clients have limited access to different financial instruments, resulting in low substitutability. Where poor information and contract enforcement make it too costly for formal financial institutions to serve small businesses and households, informal sector techniques may have an important role to play in serving these financial market segments.

Section I provides some background on initial conditions and policy reforms.

Section II presents the analytical framework used to examine market responses and performance. Section III presents the evidence on segmentation, and section IV analyzes the responses of different segments to policy reforms. Section V concludes with policy implications.


The review in "Adjustment in Africa" (World Bank 1994) acknowledges the limited progress in financial sector reform in Africa and calls for some rethinking of strategy. Financial liberalization may need to be accompanied by measures to address institutional weaknesses and structural obstacles that inhibit financial market efficiency and integration.

In most African countries, the indigenous private sector consists largely of households and small-scale enterprises that operate outside the formal financial system. Analysts refer to the informal sector by many terms, such as unorganized, noninstitutional, and curb markets. Conforming to recent trends in the literature, we use the term "informal finance" to refer to all transactions, loans, and deposits occurring outside the regulation of a central monetary or financial market authority (Adams and Fitchett 1992). The semiformal sector has characteristics of both the formal and informal sectors—for example, legally registered institutions that are not directly regulated by the financial authorities.

Informal savings activities in Africa are widespread but generally selfcontained and isolated from those of formal institutions (Adams and Fitchett 1992 and Bouman 1995). There is evidence of demand for external finance by enterprises that want to expand beyond the limits of self-finance but that have historically lacked access to bank credit (Aryeetey and others 1994; Levy 1992;

Liedholm 1991; Parker, Riopelle, and Steel 1995; and Steel and Webster 1992).

Better integration among different segments of the financial system—formal, semiformal, and informal—could facilitate economic development by mobilizAryeetey, Hettige, Nissanke, and Steel 197 ing household resources more effectively and improving the flow of financial resources to enterprises with high potential (Seibel and Marx 1987).

We selected Ghana, Malawi, Nigeria, and Tanzania for this study on the basis of their reasonably comparable financial systems, financially repressive policies prior to reform in the late 1980s, well-documented financial systems, and experienced local researchers. Financial policies pursued in the four sample countries in the prereform period shared certain financially repressive characteristics, such as restriction on market entry, often coupled with public ownership; high reserve requirements; interest rate ceilings; quantitative control on credit allocation; and restrictions on capital transactions with the rest of world (Johnston and Brekk 1991; Montiel 1996).

Financial repression discouraged investment in information capital. Savings mobilization was not actively pursued. Financial systems lacked active liquidity and liability management and incentives to increase efficiency, resulting in high costs of financial intermediation. Although the nature of particular measures varied by country, in general the allocation of investible funds shifted from the market to the government. The degree of government control over banking institutions was higher in socialist-oriented Tanzania and Ghana than in Malawi and Nigeria, which encouraged indigenous private agents following independence. Governments often used banking institutions as a source of implicit taxation, for example, by imposing high reserve requirements in the range of 20-25 percent of assets (more than 80 percent in Ghana in the early 1980s) and by financing operating losses of parastatals (Collier and Gunning 1991). In the period before adjustment, the share of government and public enterprises in total domestic credit was 86 and 95 percent in Ghana and Tanzania, respectively, and well over 50 percent in Malawi and Nigeria.

Governments implemented financial sector reforms to address these conditions through liberalization and balance-sheet restructuring. The reforms decontrolled interest rates and credit allocation and included efforts to strengthen regulatory and supervisory frameworks. Although the general thrust of these measures was similar for all four countries, the initial conditions differed, including banks' and borrowers' net worth and the scale of fiscal imbalances preceding financial sector reform. Policy sequences and the pace of reforms also differed across countries. All of the countries initiated policy reforms during the period 1985-87 (although implementation in Tanzania was very slow before 1991).

Analysts frequently mention the partial nature of reforms and inadequate institution building as explanations for the disappointing outcomes of financial liberalization in Sub-Saharan Africa (World Bank 1994). The experience of the Southern Cone countries in South America shows that important conditions for successful liberalization include macroeconomic stability, prudential supervision, and an adequate regulatory framework. The financial reform programs introduced in Ghana and Malawi addressed these conditions, at least to some extent.

Ghana reduced fiscal imbalances before decontrolling the interest rate and credit allocation over a two-year period and restructured banks and their balance sheets.

198 THE WORLD BANK ECONOMIC REVIEW, VOL 11, N O. 2 The country paid early attention to strengthening the regulatory and supervisory environment and to developing money and capital markets. In Malawi, too, major fiscal and public enterprise reforms prior to financial liberalization reduced the cost of bank restructuring. The reforms gradually decontrolled interest rates and implemented institution-building measures. Neither country experienced major financial crisis.

In Tanzania problems arose from delays in restructuring parastatals, which were the banks' main borrowers. Banks' net worth deteriorated significantly as they continued to extend credit to poorly performing parastatals. Nonperforming loans accumulated, greatly increasing the cost of balance-sheet restructuring.

Thus, weaknesses on the institutional side impeded progress in policy reforms.

In Nigeria financial sector reforms were thrown into crisis by the sequencing of reform measures and the lack of the necessary prerequisites for liberalization. In particular, wholesale deregulation of interest rates and market-entry requirements in the early years aggravated the instability of the financial system.

A series of corrective measures had to be adopted, raising questions of policy credibility.

Our fieldwork shows that, in comparison with the disappointing response of formal institutions to reform measures, informal financial agents responded dynamically in the adjustment period in all four countries. In particular, we observe signs of innovation in the semiformal financial sector. However, with weak linkages between segments of the financial market, these new developments have as yet had little measurable impact on market fragmentation, resource mobilization, and financial intermediation.


Two leading theoretical paradigms in contemporary financial economics provide analytical frameworks for examining the impact of policy reforms on financial market fragmentation. These paradigms complement each other but focus on different policy-based or structural and institutional explanations.

A Policy-Based Explanation of Financial Market Fragmentation The financial repression hypothesis (McKinnon 1973; Shaw 1973; and Fry 1982, 1988) attributes underdeveloped and inefficient financial systems to government policy failures, which result from excessive intervention. The hypothesis sees repressive policies as the prime cause of fragmentation (Roe 1991).

Ceilings on deposit and loan rates tend to raise the demand for and depress the supply of funds. Unsatisfied demand for investible funds then forces financial intermediaries to ration credit by means other than the interest rate, while an informal market develops at uncontrolled rates. A fragmented credit market emerges in which favored borrowers obtain funds at subsidized, often highly negative, real interest rates, while others must seek credit in inefficient, expensive informal markets.

Aryeetey, Hettige, Nissanke, and Steel 199 In this view, removing restrictive policies should enable the formal sector to expand and thereby eliminate the need for informal finance. Financial liberalization would lead to financial deepening; improved efficiency, resulting in lower spreads between borrowing and lending rates; and increased flow of funds between segments, including better access to formal finance for previously marginalized savers and borrowers.

Structural and Institutional Explanations of Financial Market Fragmentation Other authors have concentrated on structural and institutional features of the financial markets of developing countries to explain fragmentation. Hoff and Stiglitz (1990) advance an explanation based on imperfect information on creditworthiness and differences in the costs of screening, monitoring, and contract enforcement across lenders. In the presence of imperfect information and costly contract enforcement, market failures result from adverse selection and moral hazard, which undermine the operation of financial markets. Adverse selection occurs as interest rates increase and borrowers with worthwhile investments become discouraged from seeking loans. The quality of the mix of loan applications changes adversely as interest rates increase. Further, borrowers have an incentive to adopt projects that promise higher returns but have greater risks attached. This increases the risk of default. Moral hazard occurs when some applicants borrow to pay high interest on existing loans to avoid bankruptcy or borrow without the intention or the capacity to pay back loans. Thus the level of interest rates affects the risk composition of financial portfolios (Stiglitz and Weiss 1981 and Stiglitz 1989). Concerned about greater risk, lenders may resort to nonprice rationing rather than raise interest rates when faced with excess demand for credit. As a result, credit rationing may characterize market equilibrium even in the absence of interest rate ceilings and direct allocation. Liberalized markets do not necessarily ensure Pareto-efficient allocation (Stiglitz 1994).

Problems arising from imperfect information are likely to be most pronounced in low-income countries, where information flows are limited by poor communications, and gathering information is often costly. Poor information systems encourage segmentation by raising the cost to formal institutions of acquiring reliable information on both systemic and idiosyncratic risks for all but the largest clients. In contrast, informal agents rely on localized, personal information that gives them local monopoly power but constrains their ability to scale up.

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